Occasionally there are excellent articles that truly encapsulate what is currently happening in the U.S. economy. There has been a marked and sustained upward movement in financial markets over the six weeks, based on presumptions that "green shoots" of recovery are evident. However, this is nothing more than a sham. By year-end 2009, the stock market will be a lot lower than the level we see right now--possibly the Dow falling below 6,000. In order to understand our current economic status, one must adequately assess the historical background and the effects of the policies enacted. All leads to an unhappy ending. While lengthy, it is certainly a good investment of time to read it. It can save you A LOT of money if you act accordingly.
The mirage of recovery
By Hossein Askari and Noureddine Krichene **
Over recent days, observing a sudden increase in car sales and record profits of "bankrupt" banks, Federal Reserve chairman Ben Bernanke has announced that recovery of the US economy was under way. Treasury Secretary Timothy Geithner echoed the same message and even "globalized" his prediction of a recovery for the world economy. President Barack Obama saw "glimmers of hope". While these three top US policymakers were rushing to announce recovery, economist Paul Krugman exuded skepticism, saying "do not count your recoveries before they are hatched".
US policymakers' optimism seems to be founded on their grandiose reflationary programs. Obama has launched an unprecedented stimulus package at US$787 billion, followed by the largest US fiscal deficit ever, at $1.85 trillion, or 13% of gross domestic product (GDP). Underlying the stimulus package and the fiscal deficit was a Harvard income multiplier of 1.5, implying an increase in the US real GDP by about $4 trillion, or a record 30% per year. The basic economics advocated by the Obama team were simple: trillions of dollars in stimulus package and government expenditures would boost real aggregate demand for consumption and investment and automatically lead to economic recovery and full employment. Their mechanical multiplier model provided a strong reason for Obama to announce a premature economic recovery.
Bernanke's optimism is the result of the aggressive monetary policy that he forced under the George W Bush administration and has continued to expound under Obama, irrespective of the devastation it has caused to the banking sector and subsequent fiscal bailouts. Bernanke has gained the reputation of the doctor of the "Great Depression" and proponent of monetary anarchy. For him and his school of thought, inflation seems to be of little concern. His aggressive monetary policy has sent the US economy, and with it the world economy, into financial collapse and recession.
Yet, doctor Bernanke kept strong faith in his aggressive anti-Great Depression medicine. Besides forcing interest rates to zero, never seen in the monetary history of the US, he decided to unleash money supply by expanding the credit of the Federal Reserve from $700 billion prior to August 2007 to $2.3 trillion by end April 2009. Doctor Bernanke's reasoning was simple: zero interest rates combined with unlimited credit to the sub-prime markets ought to hike up aggregate demand in such a powerful way that it blasts away recession and secures fast growth and full employment.
The recent cheers for Geithner were based on similar reasoning, however, transplanted at the world economic level. A Group of 20 stimulus package of $5 trillion, on the top of a commitment by the G-20 countries to undertake the most expansionary fiscal and monetary policy, combined with free lending to any country in any amount, that would in their view guarantee a fast and strong world economic recovery.
Neither G-20 policymakers nor the US seem to recognize that the current recession was the product of overly expansionary fiscal and monetary policies during the past decade. Obviously, these policies yielded a temporary high demand-led economic growth during the 2002-2007 period accompanied by the highest commodity price inflation in recent memory; however, they also triggered a food and energy crisis, general bankruptcies in form of meltdown of sub-prime loans, an economic recession and trillion of dollars of bailouts in the US and Europe that socialized financial losses. These bailouts will weigh on economic growth for a long time in the future.
These same policies are now being replayed around the world. The supporters of these policies claim to be innovative as if for the first time in history they were implementing voluminous fiscal expansion and the free printing of money. Yet these policies were used time and again in the past with startling examples such as the German hyperinflation in 1920-23, Latin American hyperinflations in 1950-1985, and the more recent Mobutu and Mugabe hyperinflations.
In all cases where these policies were tried, there was devastating inflation, a substantial decline in real income and a considerable impoverishment and social malaise. Notwithstanding historical evidence against rapid monetary and fiscal expansionism, G-20 policymakers and the US now believe in success of super inflationary policies.
US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the large external deficits that reached about 6% of GDP in recent years and negative national savings. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration's war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.
Bernanke blamed the financial crisis on China and on oil exporters who invested their balance of payments surplus in the US, leading to low interest rates and a credit boom in the US, thus denying Fed influence on interest rates and credit creation. Certainly, Bernanke did not understand that China and oil exporters do not decide the US current account deficit.
Often, Bernanke has noted that the Fed's mandate from the Congress was to promote maximum sustainable employment and stable prices. The failure of the Fed to achieve either or both objectives has been quite recurrent over the past decades. Bernanke's aggressive policy since August 2007 has even triggered stagflation: rising unemployment and inflation. It would be more natural to have a central bank with one single mandate - to preserve the value of money.
Bernanke has simply dismissed traditional central banking and decided, based on his own Great Depression doctrine, to go beyond the twin mandates that were prescribed by the Congress and to create high-risk instruments that go beyond traditional government bonds held by a central bank for open market operations. No central bank has the mandate to lend directly to non-depository banks or to the private sector. That would constitute a violation of standard central banking practice. No government in the world would allow its central bank to violate its mandate and hold assets other than government bonds and member banks' discounts. The arbitrary and overly discretionary power of Bernanke can be illustrated by the following passage from Bernanke:
"More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. ... Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool - namely, buying securities in the open market. The FOMC [Federal Open Market Committee] has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5%, the lowest level since the 1940s." (Speech delivered at Morehouse College, Atlanta, Georgia, on April 14, 2009.)
Bernanke does not seem to understand the nature of credit. A bank lends deposits it receives from its depositors and from repayments of loans. When borrowers do not pay back, the bank no longer has the capital to lend. Bernanke interpreted the credit freeze as a liquidity problem and had little idea about the extent of frozen portfolios. His massive liquidity injection translated into a mountainous buildup of banks' holding of excess reserves that reached $862 billion as of end-April 2009 against less than $2 billion prior to September 2008.
Bernanke was fooling the public by saying he wanted to free up the flow of credit to households and small business, forgetting that most of outstanding loans to households and small business were simply lost and written down. He forgot the bailouts he extended under the Troubled Asset Relief Program to banks in replacement of lost portfolio. He was oblivious about the nature of credit.
Banks accord credit to borrowers from the savings of their depositors. The Fed does not receive deposits from households; it is not intermediating between savings and lending and therefore cannot be considered to be freeing up credit. It is purely creating money out of thin air. As such, the Fed has become a taxing authority that confiscates wealth and redistributes it to lucky borrowers. The new mandate for taxation and redistribution has been self-attributed by Bernanke. Other new mandates were insuring the highest car sales and highest credit card, student, and small business loans. Bernanke has also extended his role to the housing market, with the aim of preventing a downward adjustment of housing prices and pushing down interest rates. Bernanke wanted to renew the speculative euphoria that characterized the housing market under his predecessor Alan Greenspan.
Bernanke does not believe in any regulation of the financial system. By pushing trillion of dollars in liquidity to the sub-prime market, he is likely to bankrupt the Fed within a few short years. Loans pushed on borrowers will never be repaid. Moreover, consumer loans by definition finance consumption. Contrary to investment loans that generate income for their repayment, consumer loans generate no income and cannot be repaid. A stress test applied to the Fed itself would surely predict a huge lost portfolio.
While banks have already been bankrupted and are no longer ready to play out in the hands of Bernanke again, he has decided to go on his own, turning a central bank into an all-encompassing institution, showering free money to consumers and reaching out once again to ninja's - no income, no job, no asset, borrowers. The injection of over $1.25 trillion in mortgages is already setting off another speculative wave, with speculators surging everywhere after high commissions and profits and enticing borrowers into cheap loans that are secured by Bernanke's Fed.
Bernanke considered the rise in car sales as a sign of economic recovery. When Bernanke has become himself the car dealer of the US, handing out luxury cars for free, could this rise in car sales be considered as a sign of recovery? Certainly, the rise in car sales did not reflect savings and growth in the economy. It only reflected Bernanke's overly cheap monetary policy. Bernanke's successor will be saddled with trillions of dollars in bad loans and faced with uncontrollable inflation. A Fed saddled by a mountain of bad debt should be the cause of serious concern for Obama.
Most astonishing of Bernanke's magic tricks is to turn bailout banks into record-profit-making banks in such a record time, while Geithner is still setting up his toxic asset banks. The TARP money served to pay bonuses to managers. Why not use some for paying bonuses to stockholders? Moreover, the Fed is paying an interest on excess reserves held by banks following massive liquidity injection. That interest could be considered as another subsidy to banks that contributes to create illusory profits and the mirage of economic recovery. Banks' profits are not rising from real economic activity and are pure bailout money and subsidies from the state.
How much credibility could be accorded to the soothsayers Bernanke and Geithner? It would be safer to talk about recovery when it really has occurred and strengthened over a period of a few quarters, not through distorted indicators such as those manipulated by Bernanke, but through real GDP growth and a pick up in general employment. If durable growth occurs in such incredible fiscal and monetary chaos, then the disastrous experience of countries that undertook these policies would be baffling. Namely, Zimbabwe should not have experienced four digit inflation and its employment and real income should have grown at highest possible rates.
High US inflation, while not admitted by US policy makers, has eroded real income, had reduced dramatically food consumption, and has certainly caused rising unemployment. The more an economy is inflated, the more its real activity is deflated and the more unemployment rises. The creation of money out of thin air could lead to starvation. Others have called it counterfeiting. Counterfeiters could bring as much stimulus and confiscation as does Bernanke's money creation.
Paul Volcker applied prudent central banking soon after his appointment as Fed chairman in 1979 and achieved a durable recovery in a financial environment of strong and healthy banks by tightening monetary policy and allowing the federal funds rate to remain at 19% for several quarters. He did not invent tricks. Bernanke had caused financial disorder by pushing his theory of anti-Great Depression ever since he was appointed as a governor in 2002 and later as a chair of the Fed in 2006.
He announced recovery with zero interest rates, bankrupted financial system, unorthodox central banking, and most expansionary money creation in the US history. He has kept on inventing tricks and showing genius and innovation. Certainly there is a huge dichotomy between Volcker's plain-vanilla prudent banking and Bernanke's advanced and dangerous financial engineering. But it can be easily solved when we recognize that all roads lead to Rome.
While the Volcker recovery proved to be real, the Bernanke pick-up has so far been a mirage. Bernanke has announced that the Fed credit is to expand to $4 trillion by end-2009. Besides the effects of a breakout of the swine flu, over the coming months and years we also have the results of the Bernanke credit breakout to look forward to.
**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.