Ares
20th October 2010, 06:57 PM
By Hossein Askari and Noureddine Krichene
In announcing a new round of money printing, or quantitative easing round 2 (QE2), US Federal Reserve chairman Ben Bernanke has sent more shock waves around the world. Instead of "easing" markets as the term QE2 might imply, he has "scared" the living daylights out of financial markets.
In the process, Bernanke may be about to irreparably deepen the hole that the Fed dug for the US and world economies in 2002-2008. It may be time to fasten seatbelts, as a new round of financial disorders and currency wars are on the horizon. Although QE2 was projected to begin in November 2010, markets have already reacted violently just at the thought of it. Gold was pushed to new nominal highs at close to US$1,400 an ounce and the dollar into what appeared to be a free fall before this week's rise in Chinese interest rates sent some risk-averse investors back to the greenback as they worked out the implications of Beijing's monetary tightening.
In his speech entitled "Monetary Policy Objectives and Tools in a Low-Inflation Environment" delivered on October 15, 2010, at a conference sponsored by the Federal Reserve Bank of Boston, Bernanke said: "... as I indicated earlier, one of the implications of a low-inflation environment is that policy is more likely to be constrained by the fact that nominal interest rates cannot be reduced below zero. Indeed, the Federal Reserve reduced its target for the federal funds rate to a range of 0 to 25 basis points almost two years ago, in December 2008. Further policy accommodation is certainly possible even with the overnight interest rate at zero ... For example, a means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery."
He remains far removed from reality. And as in the past, since joining the Fed in 2002, he appeared oblivious to the disastrous consequences of his most unorthodox policies. In 2010, Bernanke believes inflation to be dangerously low (at 1.1%), resulting in unprecedented continuation of unemployment and threatening the US economy with deflation. Bernanke claimed that interest rates cannot go below zero, ie the level at which they stand now, so additional non-conventional tools have to be employed to inject more liquidity into the economy, forcing inflation to higher rates and driving real interest rates to become negative.
Even the title of his speech was curious. Which low-inflation environment was Bernanke referring to? With gold prices skyrocketing to near $1,400 an ounce, the dollar collapsing from $1.18 to the euro to $1.41, food prices flying sky high, US fiscal deficits near historic records, the country's external deficits widening, and the banking sector saddled with mountainous mortgage defaults and stepping up foreclosures, it would appear that Bernanke's low inflation environment was a figment of his own imagination.
The collapse of the dollar can, with time, be but only inflationary. Bernanke claimed that inflationary expectations were non-existent and that investors were predicting deflation. His reading of inflationary expectation was deduced from the yield curves on government bonds. To the extent that the Fed directly sets interest rates at zero-bound, his reading of inflationary expectations is as distorted as the interest rate structure that he has forced since 2002.
Nobel Prize Laureate Robert Mundell pointed out in a Wall Street Journal article on October 16 that inflationary expectations were measured by the price of gold and were, therefore, high. "The price of gold is an index of inflation expectations," Mundell said without hesitation. "The rising price of gold shows that people see huge amounts of debt being accumulated and they expect more money to be pumped out."
The Fed's inflation gauge has been stuck for the past 10 years in the narrow range of 1%-2%, on what is called "core inflation". Core inflation measures the price indices of "core products" such as toys, video games and cigarettes. It leaves out the price of "non-core products" such as crude oil, rice, wheat, corn, fruits, vegetables, utilities, and transports.
Analysts have pondered that if core inflation were at 1%, then "true" core inflation adjusted for productivity gains assumed to be at the 5% level would be 6%. So far in 2010, the price of crude oil has jumped by 27%, corn by 63%, wheat by 84%, sugar by 55%, and soybeans by 24%. The dollar has fallen rapidly.
All these prices are instantly transmitted to retail prices in the US. Hence non-core inflation, that is the inflation of these vital products, has been probably moving at a double-digit rate. Yet, it would appear that this inflation is totally irrelevant to Bernanke. His policy objective was to make core inflation go up at a higher rate, regardless of the implications on non-core inflation. In other words, if the price inflation of toys remains at 1.1%, then this is dangerous for the US economy, causing unemployment and in conflict with the Fed's mandate to maintain inflation at a higher level consonant with full employment, but food-price inflation be damned, whatever the rate!
Ever since 2002, the Fed, as well many academicians and policymakers, has been caught up in a sterile policy debate: inflation versus deflation. In the 19th and early 20th century, this debate was seen as futile and that monetary policy should be conducted not according to price indices, as there are thousands of potential price indices with each special interest group wanting a price index that serves its interest, but by controlling the monetary base, the so-called currency school.
Recall the events of a few years ago. When housing prices rose by a multiple of two, three, and four, was this increase signaling inflation? When oil prices fell from $147 a barrel to $80, should this have been seen a dangerous deflation? Should the oil price instead have been forced to $500 a barrel to prevent a deflation? Was the drop of corn prices from $800 per tonne to $400 a terrible deflation? Should these prices have been pushed to $1,200 per tonne, starving millions of people, in order to preempt deflation? If one looks at the rise of oil prices from $20 per barrel to $80, there was inflation of 400%; if one looks at the subsequent drop from $147 to $80 per barrel, there was deflation of 46%. What is the appropriate base for assessing inflation and deflation?
In his speech, Bernanke contended the "empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery".
Bernanke's contention is debatable. It could be persuasively argued that it was the drop in oil prices from $147 to $40 and food prices from starvation levels to affordable levels that enabled the economy to recover. All vital sectors in 2008, such as agriculture, airlines, auto-industry, and transports, were paralyzed when oil climbed to $147. The whole world economy stalled.
What do we have to show after eight years of these questionable policies? The US has been paralyzed by the worst financial crisis in the post-World War II era. Two decades of economic prosperity have been brought to a screeching halt - with fiscal deficits at record levels of 13% of gross domestic product (GDP), external deficits at 5%-7% of GDP, a ravaged housing sector, unemployment stuck in the 9.5-10% range, declining real incomes and with poverty rates continuing to climb.
The noted Yale economist Irving Fisher (1933) reviewed 49 possible causes of economic dislocation. He was convinced that only cheap monetary policy could cause economic recession and bankruptcies of the scale seen in 1929-1935, 1907, and the episodes during the 19th century.
While the Fed should take much of the blame for the economic recession and financial collapse that has plagued the US, there is more to come.
The new round of quantitative easing will inflict heavy damage on the US economy. The more money the Fed prints and pushes out onto banks, the higher is the risk of a total collapse of the banking system. Fed policies have created deep distortions and inequities in the economy. Fed policies have robbed savers of any income. Before tax savings pay less than 0.5% a year and after tax savings pay less than 0.30%. Allowing for double-digit non-core inflation, savers' real interest incomes have become drastically negative, translating into losses in real capital. High inflation will erode real incomes of workers and pensioners and depress their consumption and living standards.
The Fed has been desperate to re-inflate the economy with a view to reducing real debt for borrowers and depreciating dramatically the dollar to propel exports. This can happen only if other countries fall for the Fed's trap and let it depreciate the dollar at will and thus allow their currencies appreciate relative to the dollar by the same proportion.
Central banks are now being forced into competitive devaluations (something that we were sure would happen, about two years ago, if countries were not vigilant), barring retaliation in the form of quotas or tariffs, which would be illegal under the World Trade Organization arrangements.
The dollar may depreciate vis-a-vis commodities and gold to a point where the supply of commodities could be retrenched, as was the case in 2007-2008 when commodity producers decided to curtail their supplies in context of a declining dollar. Such a scenario can be hardly ignored. Producers would not be willing to sell valuable goods for worthless paper.
We are witnessing a similar phenomenon on the part of US banks that are reluctant to play the Fed's game and lend to risky borrowers in such an economic climate. If they do, they will go out of business following the fate of savings and loans associations in 1980s and Lehman Brothers in 2008.
Just look at the irrational and shortsighted policies of our leaders. The US Congress recently introduced a bill to impose sanctions on China. Treasury Secretary Timothy Geithner called on the International Monetary Fund to turn the surplus of some countries into deficits by forcing them to adopt policies that some might call the mismanagement policies of the US. This would raise dangerous questions about tampering with the sovereignty of a country and undermining its orderly fiscal and monetary policies to serve the interest of another country.
Instead of punishing China, the US and Europe should change their own policies. And yes, they might even learn something from the experience of some emerging market economies.
China kept its policy interest rate at 5.31% during the peak of the recent crisis and was able to expand its economy at a time when its exports plummeted. Its domestic expansion resulted in an economic growth rate of 9.1% in 2009. During the same time, US growth was a negative 2.6%, failing to engineer a domestic expansion in part because it kept its interest rates at zero-bound, with fiscal deficits high, and prevented the needed adjustment in housing prices.
The US policymakers, including the Fed, did not appreciate the fact that attempts to re-inflate housing prices with zero-interest rates and a $1.5 trillion purchase of mortgage backed securities by the Fed could only compound and continue the housing crisis for many more years. The housing crisis could have been solved, as in many other countries, by letting housing prices adjust downward from their speculative levels to fundamental levels determined by income and cost.
It would appear that the Fed is on the warpath again. It acknowledges no mistakes. The Fed was not moved by the energy and food crisis of 2007-2008, until markets crashed on their own, spreading general bankruptcies and widespread unemployment in the US and Europe. Although president George W Bush appointed Bernanke, his re-appointment by President Barack Obama must have been in part based on his sanguine view of inflationism. The Obama administration needed to finance record fiscal deficits at near-zero interest rate, a form of indirect taxation through printing money and paying very low interest rates. Hence, Bernanke was the ideal choice, with strong political support from politicians, media, and academicians. Speculators could never have dreamt of happier days with such free liquidity and free-wealth for the taking.
While the Fed's new round of money printing and lower interest rates have already spread uncertainties and countervailing policies, the world may have learned some lessons from the financial crisis. Some countries have acted ahead of the effective implementation of QE2 to prevent any appreciation of their currencies through direct intervention in foreign exchange markets or imposing tax on capital inflows or yields.
Central banks and investors are rushing to gold to immunize their foreign reserves from currency depreciation. Countries in the eurozone have already adopted austerity programs to squeeze imports and expand exports through greater competitiveness.
The annual meetings of the IMF and the World Bank in October 9-10 achieved nothing in the quest to preserve financial stability and invigorate world economic growth. They ended in confrontation, simply because they had the wrong agenda, namely attacking China and seeking to coerce it into economic mismanagement and renouncing its export markets, so that the US and Europe could expand their markets.
It is absurd to ask Toyota to cut its production and sales in order for Chrysler and Peugeot to expand their markets. That is not the way markets work. Asking one country to revalue its currency and another country to devalue is an unworkable approach. If the US and Europe want to address currency instability, then they should convene a conference to design a new international payments system that affords increased stability.
The Seoul G-20 Summit scheduled for November will in all likelihood be another failure if it retains the same agenda - currency revaluation and external surpluses - as the recent IMF-World Bank meetings. Reforms of the international monetary system have been called for since the late 1960s when the stress and strains of the Bretton Woods system emerged. Evidently, the present monetary system is in dire need of reform.
The Seoul meeting has no reform plan; it could, however, be an opportunity for monetary cooperation. External imbalances have been a concern for about a decade and cannot be blamed on China. It would be absurd to ask China to cut back its exports so that the US can expand its exports and reduce its external deficits. The US external imbalances can be solved by the US itself by reducing fiscal deficits and restraining its monetary policies.
http://www.atimes.com/atimes/Global_Economy/LJ21Dj02.html
In announcing a new round of money printing, or quantitative easing round 2 (QE2), US Federal Reserve chairman Ben Bernanke has sent more shock waves around the world. Instead of "easing" markets as the term QE2 might imply, he has "scared" the living daylights out of financial markets.
In the process, Bernanke may be about to irreparably deepen the hole that the Fed dug for the US and world economies in 2002-2008. It may be time to fasten seatbelts, as a new round of financial disorders and currency wars are on the horizon. Although QE2 was projected to begin in November 2010, markets have already reacted violently just at the thought of it. Gold was pushed to new nominal highs at close to US$1,400 an ounce and the dollar into what appeared to be a free fall before this week's rise in Chinese interest rates sent some risk-averse investors back to the greenback as they worked out the implications of Beijing's monetary tightening.
In his speech entitled "Monetary Policy Objectives and Tools in a Low-Inflation Environment" delivered on October 15, 2010, at a conference sponsored by the Federal Reserve Bank of Boston, Bernanke said: "... as I indicated earlier, one of the implications of a low-inflation environment is that policy is more likely to be constrained by the fact that nominal interest rates cannot be reduced below zero. Indeed, the Federal Reserve reduced its target for the federal funds rate to a range of 0 to 25 basis points almost two years ago, in December 2008. Further policy accommodation is certainly possible even with the overnight interest rate at zero ... For example, a means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery."
He remains far removed from reality. And as in the past, since joining the Fed in 2002, he appeared oblivious to the disastrous consequences of his most unorthodox policies. In 2010, Bernanke believes inflation to be dangerously low (at 1.1%), resulting in unprecedented continuation of unemployment and threatening the US economy with deflation. Bernanke claimed that interest rates cannot go below zero, ie the level at which they stand now, so additional non-conventional tools have to be employed to inject more liquidity into the economy, forcing inflation to higher rates and driving real interest rates to become negative.
Even the title of his speech was curious. Which low-inflation environment was Bernanke referring to? With gold prices skyrocketing to near $1,400 an ounce, the dollar collapsing from $1.18 to the euro to $1.41, food prices flying sky high, US fiscal deficits near historic records, the country's external deficits widening, and the banking sector saddled with mountainous mortgage defaults and stepping up foreclosures, it would appear that Bernanke's low inflation environment was a figment of his own imagination.
The collapse of the dollar can, with time, be but only inflationary. Bernanke claimed that inflationary expectations were non-existent and that investors were predicting deflation. His reading of inflationary expectation was deduced from the yield curves on government bonds. To the extent that the Fed directly sets interest rates at zero-bound, his reading of inflationary expectations is as distorted as the interest rate structure that he has forced since 2002.
Nobel Prize Laureate Robert Mundell pointed out in a Wall Street Journal article on October 16 that inflationary expectations were measured by the price of gold and were, therefore, high. "The price of gold is an index of inflation expectations," Mundell said without hesitation. "The rising price of gold shows that people see huge amounts of debt being accumulated and they expect more money to be pumped out."
The Fed's inflation gauge has been stuck for the past 10 years in the narrow range of 1%-2%, on what is called "core inflation". Core inflation measures the price indices of "core products" such as toys, video games and cigarettes. It leaves out the price of "non-core products" such as crude oil, rice, wheat, corn, fruits, vegetables, utilities, and transports.
Analysts have pondered that if core inflation were at 1%, then "true" core inflation adjusted for productivity gains assumed to be at the 5% level would be 6%. So far in 2010, the price of crude oil has jumped by 27%, corn by 63%, wheat by 84%, sugar by 55%, and soybeans by 24%. The dollar has fallen rapidly.
All these prices are instantly transmitted to retail prices in the US. Hence non-core inflation, that is the inflation of these vital products, has been probably moving at a double-digit rate. Yet, it would appear that this inflation is totally irrelevant to Bernanke. His policy objective was to make core inflation go up at a higher rate, regardless of the implications on non-core inflation. In other words, if the price inflation of toys remains at 1.1%, then this is dangerous for the US economy, causing unemployment and in conflict with the Fed's mandate to maintain inflation at a higher level consonant with full employment, but food-price inflation be damned, whatever the rate!
Ever since 2002, the Fed, as well many academicians and policymakers, has been caught up in a sterile policy debate: inflation versus deflation. In the 19th and early 20th century, this debate was seen as futile and that monetary policy should be conducted not according to price indices, as there are thousands of potential price indices with each special interest group wanting a price index that serves its interest, but by controlling the monetary base, the so-called currency school.
Recall the events of a few years ago. When housing prices rose by a multiple of two, three, and four, was this increase signaling inflation? When oil prices fell from $147 a barrel to $80, should this have been seen a dangerous deflation? Should the oil price instead have been forced to $500 a barrel to prevent a deflation? Was the drop of corn prices from $800 per tonne to $400 a terrible deflation? Should these prices have been pushed to $1,200 per tonne, starving millions of people, in order to preempt deflation? If one looks at the rise of oil prices from $20 per barrel to $80, there was inflation of 400%; if one looks at the subsequent drop from $147 to $80 per barrel, there was deflation of 46%. What is the appropriate base for assessing inflation and deflation?
In his speech, Bernanke contended the "empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery".
Bernanke's contention is debatable. It could be persuasively argued that it was the drop in oil prices from $147 to $40 and food prices from starvation levels to affordable levels that enabled the economy to recover. All vital sectors in 2008, such as agriculture, airlines, auto-industry, and transports, were paralyzed when oil climbed to $147. The whole world economy stalled.
What do we have to show after eight years of these questionable policies? The US has been paralyzed by the worst financial crisis in the post-World War II era. Two decades of economic prosperity have been brought to a screeching halt - with fiscal deficits at record levels of 13% of gross domestic product (GDP), external deficits at 5%-7% of GDP, a ravaged housing sector, unemployment stuck in the 9.5-10% range, declining real incomes and with poverty rates continuing to climb.
The noted Yale economist Irving Fisher (1933) reviewed 49 possible causes of economic dislocation. He was convinced that only cheap monetary policy could cause economic recession and bankruptcies of the scale seen in 1929-1935, 1907, and the episodes during the 19th century.
While the Fed should take much of the blame for the economic recession and financial collapse that has plagued the US, there is more to come.
The new round of quantitative easing will inflict heavy damage on the US economy. The more money the Fed prints and pushes out onto banks, the higher is the risk of a total collapse of the banking system. Fed policies have created deep distortions and inequities in the economy. Fed policies have robbed savers of any income. Before tax savings pay less than 0.5% a year and after tax savings pay less than 0.30%. Allowing for double-digit non-core inflation, savers' real interest incomes have become drastically negative, translating into losses in real capital. High inflation will erode real incomes of workers and pensioners and depress their consumption and living standards.
The Fed has been desperate to re-inflate the economy with a view to reducing real debt for borrowers and depreciating dramatically the dollar to propel exports. This can happen only if other countries fall for the Fed's trap and let it depreciate the dollar at will and thus allow their currencies appreciate relative to the dollar by the same proportion.
Central banks are now being forced into competitive devaluations (something that we were sure would happen, about two years ago, if countries were not vigilant), barring retaliation in the form of quotas or tariffs, which would be illegal under the World Trade Organization arrangements.
The dollar may depreciate vis-a-vis commodities and gold to a point where the supply of commodities could be retrenched, as was the case in 2007-2008 when commodity producers decided to curtail their supplies in context of a declining dollar. Such a scenario can be hardly ignored. Producers would not be willing to sell valuable goods for worthless paper.
We are witnessing a similar phenomenon on the part of US banks that are reluctant to play the Fed's game and lend to risky borrowers in such an economic climate. If they do, they will go out of business following the fate of savings and loans associations in 1980s and Lehman Brothers in 2008.
Just look at the irrational and shortsighted policies of our leaders. The US Congress recently introduced a bill to impose sanctions on China. Treasury Secretary Timothy Geithner called on the International Monetary Fund to turn the surplus of some countries into deficits by forcing them to adopt policies that some might call the mismanagement policies of the US. This would raise dangerous questions about tampering with the sovereignty of a country and undermining its orderly fiscal and monetary policies to serve the interest of another country.
Instead of punishing China, the US and Europe should change their own policies. And yes, they might even learn something from the experience of some emerging market economies.
China kept its policy interest rate at 5.31% during the peak of the recent crisis and was able to expand its economy at a time when its exports plummeted. Its domestic expansion resulted in an economic growth rate of 9.1% in 2009. During the same time, US growth was a negative 2.6%, failing to engineer a domestic expansion in part because it kept its interest rates at zero-bound, with fiscal deficits high, and prevented the needed adjustment in housing prices.
The US policymakers, including the Fed, did not appreciate the fact that attempts to re-inflate housing prices with zero-interest rates and a $1.5 trillion purchase of mortgage backed securities by the Fed could only compound and continue the housing crisis for many more years. The housing crisis could have been solved, as in many other countries, by letting housing prices adjust downward from their speculative levels to fundamental levels determined by income and cost.
It would appear that the Fed is on the warpath again. It acknowledges no mistakes. The Fed was not moved by the energy and food crisis of 2007-2008, until markets crashed on their own, spreading general bankruptcies and widespread unemployment in the US and Europe. Although president George W Bush appointed Bernanke, his re-appointment by President Barack Obama must have been in part based on his sanguine view of inflationism. The Obama administration needed to finance record fiscal deficits at near-zero interest rate, a form of indirect taxation through printing money and paying very low interest rates. Hence, Bernanke was the ideal choice, with strong political support from politicians, media, and academicians. Speculators could never have dreamt of happier days with such free liquidity and free-wealth for the taking.
While the Fed's new round of money printing and lower interest rates have already spread uncertainties and countervailing policies, the world may have learned some lessons from the financial crisis. Some countries have acted ahead of the effective implementation of QE2 to prevent any appreciation of their currencies through direct intervention in foreign exchange markets or imposing tax on capital inflows or yields.
Central banks and investors are rushing to gold to immunize their foreign reserves from currency depreciation. Countries in the eurozone have already adopted austerity programs to squeeze imports and expand exports through greater competitiveness.
The annual meetings of the IMF and the World Bank in October 9-10 achieved nothing in the quest to preserve financial stability and invigorate world economic growth. They ended in confrontation, simply because they had the wrong agenda, namely attacking China and seeking to coerce it into economic mismanagement and renouncing its export markets, so that the US and Europe could expand their markets.
It is absurd to ask Toyota to cut its production and sales in order for Chrysler and Peugeot to expand their markets. That is not the way markets work. Asking one country to revalue its currency and another country to devalue is an unworkable approach. If the US and Europe want to address currency instability, then they should convene a conference to design a new international payments system that affords increased stability.
The Seoul G-20 Summit scheduled for November will in all likelihood be another failure if it retains the same agenda - currency revaluation and external surpluses - as the recent IMF-World Bank meetings. Reforms of the international monetary system have been called for since the late 1960s when the stress and strains of the Bretton Woods system emerged. Evidently, the present monetary system is in dire need of reform.
The Seoul meeting has no reform plan; it could, however, be an opportunity for monetary cooperation. External imbalances have been a concern for about a decade and cannot be blamed on China. It would be absurd to ask China to cut back its exports so that the US can expand its exports and reduce its external deficits. The US external imbalances can be solved by the US itself by reducing fiscal deficits and restraining its monetary policies.
http://www.atimes.com/atimes/Global_Economy/LJ21Dj02.html