By Hossein Askari and Noureddine Krichene
United States Federal Reserve chairman Ben Bernanke recently announced he would be again mounting a full-court monetary press. His announcement of another round of quantitative easing (QE2) - that is, a massive purchase of bonds to drive down the already low interest rates, and to force inflation above the level that would make real interest rates largely negative, has jolted markets and heightened uncertainties.
His announcement sent gold prices racing to a fresh nominal record of $1,364 per ounce, leaping by about 15% in only one week, and the US dollar went into free-fall. The rapid increase in gold prices is an indication of strong inflationary expectations and a loss of confidence in key currencies. During this year, gold has appreciated by over 34%. The flight to gold has been largely a flight to safety and a hedge against expected inflation. As leading central banks have embarked on what has been the most unorthodox monetary policy of all time, investors and holders of foreign currency reserves could not wait until the fire burned their wealth to paper ashes.
With gold soaring, it is a strong indication that central banks have failed in their near-zero interest rate policy and unprecedented liquidity injection to restore confidence, encourage investment, and fuel the strong recovery that has been long promised in Group of 20 (G-20) summits.
Instead, central banks are now entangled in currency manipulation and competitive
In 2007-2008, Bernanke's loose monetary policy fueled unprecedented commodity price inflation. But Bernanke put the blame on China and on oil producers. So far in 2010, the price of crude oil has jumped by 27%, of corn by 63%, of wheat by 84% , of sugar by 55% , and of soybeans by 24%. Without the Fed's unprecedented loose monetary and near-zero interest rates, it would have been highly unlikely for commodity prices to increase at these alarming rates. The rise in wheat, corn, sugar, and soybean and many other commodities prices could be blamed on bad crops. However, such rapid increases could hardly be possible without unlimited liquidity.
Today the yield on commodities far outstrips the yield on US Treasuries. Holding gold would have yielded 34% in less than a year, holding a Treasury note would have yielded a nominal 1%. Likewise, holding wheat futures contract or storing wheat would have yielded 84% in less than one year.
The frightening food price inflation has raised the specter of another food crisis and food riots. High commodity inflation is an indicator of scarcity of real capital and very low savings for sustaining economic growth and employment creation. High food and energy prices are instantly transmitted to retail prices. Consumers suffer dramatic losses in their real incomes and are forced into scrimping on food, and in the case of consumers in the US to relying on food stamps. Since liquidity for commodity price inflation is abundant and cheap, food price inflation could run up, stall world economic growth and spread social unrest.
While we worry about food price inflation, the Fed with its obsession on core inflation dismisses any talk of inflation. Fed governors should do their family grocery shopping and then talk. They should talk to ordinary Americans and see what they say about food prices after each visit to the supermarket.
It would be unfair to claim that Bernanke's policy did not make some of us happy. As before, his policy has been most propitious for speculation. It has been almost a free lunch for borrowers and speculators. Hedge funds reported their biggest gains of the year in September 2010. Managers assumed more risk in the context of abundant cheap liquidity and more quantitative easing in sight. Some hedge funds netted an increase of 12% in the value of their portfolios in September, while some commodity funds netted an increase of 15%. Near-zero interest rate policy has created ample arbitrage opportunities for reaping almost free wealth based on un-mistaken policy setting and almost sure trends in commodity and asset prices. Namely, there are no prospects for Bernanke to renounce his monetary unorthodoxy any time soon.
The Fed quantitative easing in 2002-2005, through setting interest rates at 1% and injecting enormous amount of money, in large part fueled the housing boom and precipitated the collapse of the housing market. QE in 2007 accelerated commodity price inflation and sent oil and food prices to unprecedented levels, in turn stalling the world economy with unemployment rate rising rapidly from 4% in 2007 to over 10% in 2009. Since September 2008, QE after two years has not achieved the quick turn-around and full employment promised by the Fed. The Fed could be likened to a gambler who each time doubles the stakes to recoup past losses.
Regardless of vast damage caused by ultra loose monetary policy, Bernanke is still confident that stepping up QE will bring about prosperity. Near-zero interest rates do not make capital cheaper, oil prices shot up to $147, wheat prices more than doubled, and corn prices more than tripled.
For a moment assume that the Fed purchases $2 trillion in bonds. Pundits estimated that this mountain of liquidity would reduce the already very low long-term interest rate by at most 50 basis points (bp) from 3.25% to 2.75%. Why hasn't credit expanded while interest rates have been so low, and negative in real terms? What makes credit expand by $2 trillion when long-term interest rates fall by 50 bp? These are questions that Fed cannot answer. With the credit-to-GDP ratio at a record peak of 350% in 2010, high uncertainty, little confidence, banks saddled with toxic assets, and very low lending rates, it would be difficult to envisage banks rushing to their deathbed by lending to the bankrupt subprime sector yet again.
Obviously, when the Fed injects $2 trillion, or more, of paper money to the economy it does not add even one gram of corn or one drop of oil. It creates huge amount of money out-of-thin air. Its action immediately alters wealth and income distribution and distorts prices. The size of distortions is directly related to the quantity of liquidity; the more liquidity is brought in, the more severe the distortions. The Fed grabs real wealth from one group and redistributes to another group in the name of complying with its mandate to create prosperity and jobs. Banks that play the Fed's game will face high risk that could potentially wipe them, as has already happened to Lehman Brothers.
The beneficiaries of the Fed's purchase program are bond sellers who reap capital gains when bonds are sold at very high prices; government that will sell bonds to expand fiscal deficits; speculators who reap abundant wealth at zero cost; and borrowers in subprime markets who are the only outlet for rivers of cheap money. This liquidity will finance mostly, if not only, consumption with negligible impact on investment and real capital accumulation, and will thus aggravate public sector and private sector deficits; it will increase imports and reduce exports.
Who are the losers who will pay for this free lunch? They are those on fixed incomes, mainly workers and pensioners, creditors, and holders of US dollars and US dollar-denominated assets. They will suffer from an inflation tax and will be robbed of their real wealth and income.
The injection of new liquidity in the QE2 will reduce the real savings that are needed for real investment and capital accumulation and will, thus, curtail economic growth and employment. Moreover, real capital will migrate from US towards higher yielding currencies abroad and will precipitate the downfall of the dollar. Real economic recovery cannot take place in a context of high commodity inflation, near-zero interest rates, and monetary chaos. Commodity inflation is already a leading indicator and will run ahead of recovery and will terminate it. The US and world economies could be back to the nightmares of 2007-2008: rampant energy and food inflation price and depressed economies.
The policymaker is the same: the Bernanke Fed with its ultra-loose monetary approach. Like his predecessor, Alan Greenspan, who refused to arrest assets bubbles before they crashed on their own, Bernanke continues to reject links between interest rates and housing price inflation and has remained convinced that ultra-loose monetary policy is best course for prosperity.
Three years into the crisis, the US has refused to change its monetary policy that has led to the collapse of the banking sector. If US banks release their excess reserves, today at about $1 trillion but getting ready for a further rapid take-off under QE2, they would with high probability trigger rapid inflation. The US Fed is promoting monetary competition throughout the world as each central bank is counteracting with monetary expansion.
The biggest priority for world governments is to arrest the devastating monetary expansion initiated by central banks. The stance called for by G-20 summits to unleash money unorthodoxy has turned out to be self-defeating. Governments have to agree on some form of monetary targeting and renounce interest rate setting. A monetary conference is urgently needed.
Governments have to realize that employment creation and growth should not be the goals of a central bank. The late Milton Friedman and other prominent economists argued that a central bank controls money and credit. Its mandate is to control money aggregates within safety and prudential regulations. The present policy course of the Fed could ruin the banking sector no matter how perfect the regulations. A regime of near-zero interest rate and abundant liquidity will expose banks to high risks. As in Japan, banks get bitten only once, and become reluctant to follow the course set by the central bank - to lend and assume high risk.
Policymakers in the US have to face up to the limits of monetary policy. A return to sustained economic growth cannot be achieved by simply adopting near-zero interest rate and cheap liquidity. Such policy, even if it succeeds, is most inefficient and creates distortions and asset bubbles. It will ruin the banking sector, as it had done in recent and distant past, and will create a high degree of
Full-employment can be established only by the private sector. Therefore, the market and the price mechanism have to be allowed to operate without the distortions that have been created by government and central bank policies. The US could have got out of the recession as quickly or even quicker than many other countries had it not adopted such strong re-inflationary policies. Astonishing fiscal deficits and ultra-loose money policy will intensify distortions, erode real capital accumulation, and diminish private sector confidence.