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Road to
Hyperinflation is paved with Market Accommodating Monetary Policy
By
Henry C.K. Liu
Part I: A Crisis the Fed Helped to
Create but Helpless to Cure
Part II: Central Banking History of
Failing to Stabilize Markets
Part III: Inflation Targeting
This article appeared in AToL on February 21, 2008
Milton Friedman, the 1976 Nobel laureate in economics, identified
through an exhaustive analysis of historical data the potential role of
monetary policy as a key factor in shaping the course of inflation and
business cycles, with the counterfactual conclusion that the Great
Depression of the 1930s could have been avoided with appropriate Fed
monetary easing to counteract destructive market forces.
Friedman’s counterfactual conjecture, though not provable, has
been accepted by central bankers as a magic monetary formula to rid
capitalism of the curse of business cycles. It underpins the
Greenspan-led Fed’s “when in doubt, ease” approach of
the past 2 decades which had led to serial debt bubbles, each one
biggest the previous one.
Macroeconomists, including current Fed Chairman Ben Bernanke, focus
their attention on the structure, systemic performance and behavioral
interactions of the component parts of the economy. While they defend
the merits of market fundamentalism, most neoclassical macroeconomists
subscribe to the debt-deflation view of the Great Depression in which
the collateral used to secure loans or as in the current situation, the
backing behind their derivative instruments will eventually decrease in
value, creating losses to borrowers, lenders and investors, leading to
the need to restructure the loan terms or even loan recalls. When
that happens, macroeconomists believe that government intervention is
necessary to keep the market from failing.
The term debt-deflation was coined by Irving Fisher in 1933, and refers
to the way debt and deflation destabilizes each other. De-stability
arises because the relation runs both ways: deflation causes financial
distress, and financial distress in turn exacerbates deflation. This
debt-deflation cycle is highly toxic in a debt-infested economy.
Hyman Minsky in The Financial-Instability Hypothesis: Capitalist
processes and the behavior of the economy (1982) elaborated the
debt-deflation concept to incorporate its effect on the asset market.
He recognized that distress selling reduces asset prices, causing
losses to agents with maturing debts. This reinforces more distress
selling and reduces consumption and investment spending which deepen
deflation.
Bernanke wrote in 1983 that debt-deflation generates wide-spread
bankruptcy, impairing the process of credit intermediation. The
resultant credit contraction depresses aggregate demand. Yet in a later
paper: Should Central Banks Respond to Movements in Asset Prices?
(2002) coauthored with Mark Gertler, Bernanke concludes that
inflation-targeting central banks need not respond to asset prices,
except insofar as they affect the inflation forecast. The paper refers
to a 1982 paper by Oliver Blanchard and Mark Watson: Bubbles, Rational
Expectations, and Financial Markets with the general conclusion that
bubbles, in many markets, are consistent with rationality, that
phenomena such as runaway asset prices and market crashes are
consistent with rational bubbles.
This punched a conceptual hole in Greenspan's "irrational exuberance"
description of of stock market bubble in his famous speech at the
Annual Dinner and Francis Boyer Lecture of The American Enterprise
Institute for Public Policy Research, Washington, D.C. on December 5,
1996, when the Dow Jones Industrial Average (DJIA) was at 6,437,
against
January 14, 2000, when the DJIA peaked at 11,723 and peaked again on
July 9, 2007 at 14,000 before crashing on August 15. Irrational
exuberance may well be the result of rational expectation on inflation.
Friedman’s conjecture on the effect of monetary policy on
economic cycles drew on the ideas of neoclassical welfare economist
Arthus Cecil Pigou (1877-1959) who asserts that governments can, via a
mixture of taxes and subsidies, correct market failures such as
debt-deflation by “internalizing the externalities” without
direct intervention in markets. Pigou also proposes “sin
taxes” on cigarettes and alcohol and environmental pollution.
However, Pigou’s Theory of Unemployment (1933) was challenged
conceptually three years after publication by his personal friend John
Maynard Keynes in the latter’s highly influential classic:
General Theory of Employment, Interest and Money (1936). Keynes
advocated direct government interventionist policies through
countercyclical fiscal and monetary measures of demand management, i.e.
full employment.
Macroeconomists are also influenced by the work of Irving Fisher
(1867-1947): Nature of Capital and Income (1906) and elaborated on in
The Rate of Interest (1907 and 1930), and his theory of the price level
according to the Quantity Theory of Money as express by an equation of
exchange: MV=PT ; where M=stock of money, P=price level, T=amount of
transactions carried out using money, and V= the velocity of
circulation of money. Fisher’s most significant theoretical
contribution is the insight that total investment equals total savings
(I=S), a truism that all debt bubbles violate.
The 1990s appeared to be a replay of many aspects of the 1920s when
consumers and businesses relied on cheap and easy credit in a
deregulated market to fuel an extended debt-driven boom which became
toxic when an inevitable debt crisis caused asset price deflation.
Federal Reserve banking regulations to prevent panics were ineffective
and widespread debt defaults led to the contraction of the money
supply. In the face of bad loans and worsening future prospects, banks
abruptly became belatedly conservative in their lending while they
scrambled to seek additional capital reserves which intensified
deflationary pressures. The vicious cycle caused an accelerating
downward spiral, turning an abrupt recession into a severe depression.
Bernanke points out in his Essays on the Great Depression (Princeton
University Press, 2000) that Friedman argues in his influential
Monetary History of the United States that the Great Depression was
caused by monetary contraction which was the consequence of the
Fed’s failure to address the escalating crises in the banking
system by adding needed liquidity. One of the reasons for the
Fed’s inaction was that it had reached the legal limit on the
amount of credit it could issue in the form of a gold-backed specie
dollar by the gold in its possession. Today, the Fed has no such
limitation on a fiat dollar, a condition that permits Bernanke to
suggest the metaphor of dropping money from helicopters on the market
to fight deflation caused by a liquidity crunch. Free from a
gold-backed dollar, the Fed is now armed with a printing machine the
ink for which is hyperinflation to fight deflation.
Yet in the popular press, Friedman was known also for his advocacy of
deregulated free market as the best options for sustaining economic
growth, which raises the question of the need for central banking
intervention to replace specie money of constant value with fiat
currency of flexible elasticity. A free money market under a central
banking regime is an oxymoron. Betting on Fed interest moves is the
biggest speculative force in the market. Friedman apparently did not
extend his love for free trade to the money market. The Friedman
compromise was to manage the structural contradiction with a proposed a
steady expansion of the money supply at around 2%.
Still, Friedman’s love of free markets does not change that fact
that totally free markets always lead to market failure. Free markets
need regulation to remain free. Free market capitalism, the faith-based
mantra of Larry Kudlow notwithstanding, is not the best path to
prosperity; it is the shortest path to market failure.
Unregulated markets in goods have a structural tendency towards
monopolistic market power to reduce price competition to inch towards
rising inflation. On the other side of the coin, unregulated money
markets can lead to liquidity crises that cause deflation. The
fundamental contradiction about central banking is that the central
bank is both a market regulator and a market participant. It sets the
rules of the money market game while it pretends to help market to
remain free by distorting the very same rules through the use of its
monopolistic market power as a market participant not driven by profit
motive. The Fed is a believer of free markets who at the same time does
not trust free markets. The response by ingenious market participants
to the Fed’s schizophrenia is to set up a parallel game in the
arena of structured finance in which the Fed is increasingly reduced to
the role of a mere passive spectator.
Rational Expectations
Robert Lucas, the 1995 Nobel laureate economist, also made fundamental
contributions to the study of money, inflation, and business cycles,
through the application of modern mathematics. Lucas formed what came
to be known as the “rational expectations” theory. In
essence, the theory asserts that expectations about the future can
influence economic decisions by individuals, households and companies.
Using complex mathematical models, Lucas showed statistically that
individual market participants would anticipate and thus could easily
counteract and undermine the impact of government economic policies and
regulations. Rational expectations theory was embraced by the Reagan
White House during its first term, but the doctrine worked against the
Reagan “voodoo economics” instead of with it.
Inflation Targeting
In a debt bubble, an escalating rate of inflation to devalue the
accumulated debt is needed to sustain the bubble. Thus conventional
wisdom moves toward the view that the overriding purpose of monetary
policy is to keep market expectations of price inflation anchored at a
relatively benign rate to ward off hyperinflation. This approach is
known in policy circles as inflation targeting on which Fed Chairman
Ben Bernanke is an acknowledged academic authority and for which he had
been a forceful advocate before coming to the Fed.
In May 2003, Pimco, the nation’s largest bond fund headed by Bill
Gross, having earlier pronounced a critical view on the unrealistically
low yield of General Electric bonds in the face of expected inflation,
came out in support of inflation targeting. Fed economist Thomas
Laubach, a recognized inflation targeting advocate, estimates in a
paper that every additional $100 million increase in projected Federal
annual fiscal budget deficit adds one quarter percentage point to the
yield on 10-year Treasury bonds, albeit that this estimate has been
rendered inoperative since the 1990s by dollar hegemony through which
the US trade deficit is used to finance the US capital account surplus,
reducing the impact of US fiscal deficits on long-term dollar interest
rates. Global wage arbitrage also kept US inflation
uncharacteristically low, albeit at a price of hollowing out the US
manufacturing core.
Laubach was part of the Princeton gang that included John Taylor of the
celebrated Taylor Rule, and Ben Bernanke, the money printer of late at
the Fed. (Inflation Targeting: Lessons from the International
Experience by Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin and
Adam S. Posen; Princeton University Press 2001). The Fed’s
long-held position is that Federal budget deficits raise long-term
interest rates, over which Fed monetary policy as currently constituted
has little control.
The Taylor Rule
Economist John Taylor was the editor for Monetary Policy Rules
(National Bureau of Economic Research Studies in Income and Wealth
– University of Chicago Press 1999) in which he put forth the
Taylor Rule.
The Taylor Rule states: if inflation is one percentage point above the
Fed’s goal, short-term interest rate should rise by 1.5
percentage points to contain it. And if an economy’s total output
is one percentage point below its full capacity, rates should fall by
half a percentage point to compensate for it. The rule was
designed to provide “recommendations” for how a central
bank should set short-term interest rates as economic conditions change
to achieve both its short-run goal for stabilizing the economy and its
long-run goal for fighting inflation.
Specifically, the rule states that the “real” short-term
interest rate (that is, the interest rate adjusted for inflation)
should be determined according to three factors: (1) where actual
inflation is relative to the targeted level that the Fed wishes to
achieve, (2) how far economic activity is above or below its
“full employment” level, and (3) what the level of the
short-term interest rate is that would be consistent with full
employment.
The rule “recommends” a relatively high interest rate (a
“tight” monetary policy) when inflation is above its target
(normally below 2%) or when the economy is above its full employment
level (normally defined as 4% unemployment, but this figure has risen
in recent years to 6%), and a relatively low interest rate (a
“loose” monetary policy) in the opposite situations. Under
stagflation when inflation may be above the Fed target when the economy
is below full employment, the rule provides guidance to policy makers
on how to balance these competing considerations in setting an
appropriate level for the interest rate. The answer is a neutral
interest rate. Yet as a practical matter, the only way to counter
stagflation is to lean on the anti-inflation bias as Paul Volcker did
during the Carter years because a neutral interest rate may extend
stagflation longer than necessary.
Although the Fed does not explicitly follow the rule, analyses show
that the rule does a fairly accurate job of describing how monetary
policy actually has been conducted during the past decade under
Chairman Greenspan. This is in fact one of the criticisms of the Taylor
Rule in that it tends to reflect Fed action rather than to guide it. On
the question whether the Fed should have leaned against accelerating
home prices during 2003-2005, Taylor rule simulations suggest that the
Fed should perhaps have been thinking of itself as one important cause
of that phenomenon in the first place.
The Mystery of Neutral Interest Rates
Journalist Greg Ip of the Wall Street Journal reported on December 5,
2005 that in a written response to a letter from Rep. Jim Saxton (R-
NJ), chairman of Joint Economic Committee of Congress, about the
meaning of a neutral interest rate as invoked by Fed Chairman
Greenspan’s testimony, Greenspan says that definitions of neutral
vary, as do methods of calculating them and that neutral levels change
with economic conditions.
Thus the concept of a neutral rate is made useless by practical
difficulties. This of course was a standard Greenspan position of
all economic concepts as the wizard of bubbleland always drove by the
seat of his pants, doing the opposite of his obscure official
pronouncements. With the Fed widely expected to raise the FFR target to
4.25% the following week in a continuation of the traditional policy of
“measured pace”, up from its low of 1% in June 2004, and
with the 10-year yield at 4.5%, the yield curve was approaching flat,
and an inversion soon if the Fed, as expected, continued its interest
rate raising policy. Historically, a flat yield curve signals
future slow growth and an inverse yield curve signals future recession.
But Greenpsan, invoking rational expectations theory, dismissed the
historical pattern by arguing that lenders were likely to accept low
long-term rates because of their expectation of future low inflation,
and this would stimulate future economic activities. So stop
worrying about the inverse yield curve. It was an attitude that
continued when an inverse yield curve emerged again in the early 2000s.
There is no denying that the US economy, as well as the global economy,
had been plagued with persistent overcapacity. And if low inflation, as
defined by the Fed, is the result of slow wage increases, where in the
world can the future expansion of demand come from? Many analysts,
particularly in the bond markets, have sharply criticized the Fed for
keeping interest rates too low for too long and ignoring signs of
incipient and insipid inflation.
In his Monday, December 5, 2005 Congressional testimony, Mr. Greenspan
reiterated his view that recent price increases were mainly a result of
“transitory factors,” such as rising oil prices. True to
his Keynesian past, Greenspan also pointed out that corporate profit
had been so high that businesses had ample room to offer higher wages
without raising prices to consumers. But of course, supply-side
economics requires corporate profits to boost return on capital rather
than boost demand by raising wages. And management never voluntarily
raises wages without being pressured to by labor strikes, let alone for
the good of the economy. To management, the only thing good for the
economy is corporate profit.
The surprisingly tentative tone of Greenspan’s residual Keynesian
outlook contrasted with the more extended attempt in his testimony on
the following Tuesday to buttress his view that core inflation, which
excludes volatile areas like food and energy prices, is likely to
remain below 2% through the end of next year. But despite his
optimism about inflation remaining under wraps, Greenspan cautioned
investors against thinking that the Fed might feel less constrained in
unwinding its cheap-money policies of the last three years from 2001 to
2004.
In the June 30, 2004 Congressional hearing, Greenspan carefully dodged
an opening question from Senator Richard C. Shelby, Republican of
Alabama and the chairman of the Senate Banking Committee, on whether
the Fed would raise the federal funds rate another quarter-point at its
August 2004 meeting. Greenspan also refused to be pinned down on what
was in many ways the most basic question: What constitutes a
''neutral'' interest rate that Greenspan claims he tries to follow that
neither provokes inflation nor slows down the economy?
Many economists have suggested that a “neutral'” fed funds
rate -- the rate charged on overnight loans between banks and the key
policy tool the Fed relies on to guide the economy -- is between 4 to
5%. That would have been a big increase from the June 30, 2004 fed
funds rate level of 1.25%.
Like the famous description of pornography from Supreme Court Justice
Potter Stewart, Greenspan said people would know the rate when it
arrived. “You can tell whether you're below or above, but until
you're there, you're not quite sure you are there,” he said.
“And we know at this stage, at one and a quarter percent federal
funds rate; that we are below neutral. When we arrive at neutral, we
will know it.”
Economists have highlighted numerous difficulties in estimating the
neutral federal funds rate in real time, including data and model
uncertainty, which can result in estimates that are off by a couple of
percentage points. These difficulties add to the challenge of
conducting monetary policy, especially when the fed funds target is
near the neutral rate, because policymakers must make their decisions
without the benefit of reliable data. Therefore, policymakers will be
especially attentive at this stage to incoming data. And, until
research finds a solution to the difficulties of estimating the neutral
rate, the conduct of policy will remain both a science and an art.
Market Expectations Undermine Inflation Targeting
The problem is that according to “rational expectations”
theory, market expectation can undermine the Fed’s inflation
targeting policy to push tolerance for inflation increasingly higher
until it reaches hyperinflation. Inflation targeting advocates
therefore argue that inflation targeting should encompass a dual
objective of holding down inflation as well as preventing deflation.
The financial press, grasping at straws in the wind to anticipate Fed
policy, highlighted Fed Chairman Bernanke’s January 10, 2008
speech at the Women in Housing and Finance and Exchequer Club Joint
Luncheon in Washington, D.C. on Financial Markets, the Economic
Outlook, and Monetary Policy as signal of the Fed standing “ready
to take substantive additional action as needed to support growth and
to provide adequate insurance against downside risks.”
Yet Bernanke also said: “any tendency of inflation expectations
to become unmoored or for the Fed’s inflation-fighting
credibility to be eroded could greatly complicate the task of
sustaining price stability and reduce the central bank’s policy
flexibility to counter shortfalls in growth in the future. Accordingly,
in the months ahead we will be closely monitoring the inflation
situation, particularly as regards to inflation expectations.”
Thus the Fed is restrained in its interest rate action not only by
actual incoming inflation data, but also by data on inflation
expectations. This means that when the market expects the Fed to cut
interest rates, it actually limits the ability of the Fed to cut rates.
After the Fed’s January 2008 unprecedented and drastic interest
rate cuts, the market has been anticipating that the European Central
Bank (ECB) would need to follow the Fed’s lead to lower euro
rates significantly. Yet while the ECB faces similar dilemma as
the Fed with regard to simultaneous vigorous inflation and slowing
growth, the ECB is limited by its singular mandate of restraining
inflation, unlike the Fed’s dual mandate of price stability and
support for growth and employment. Jean-Claude Trichet, head of
the ECB, testified in front of the European Parliament that inflation
remains the ECB’s prime focus to “solidly anchor inflation
expectations.”
The euro zone economies are saddled with a less flexible structure of
wage volatility that cannot adjust quickly to price changes as in the
US because most European wage contracts are indexed to inflation but
not to deflation. Unlike their US counterparts, European companies
cannot layoff workers as easily, or adopt a two-tier wage and benefit
regime for new workers. <>
Market expectation is focused on the inevitability of a euro-zone
slowdown form the financial market turmoil that had originated from the
US in August 2007 and on the prospect of euro interest rate reduction
in the face of asset price correction despite a strong euro against the
dollar. Yet European politics will not allow political leaders to be
complacent about a strong euro buoyant by a flight from a deteriorating
dollar while euro economies face a decline from global depression
caused by a slowdown in the US economy. In the current global
trade regime, the depreciation of the dollar will bring down the value
of all other currencies. Exchange rate fluctuations only reflect
temporary differentials in the rate of decline in the purchasing power
of different currencies. Even as the euro falls against the dollar, it
continues to lose real purchasing power.
Democrat-Controlled Congress Wants Employment Targeting
As early as February 19, 2007, half a year before the August emergence
of the credit crisis, Representative Barney Frank of the 4th
Congressional District of Massachusetts, the Democratic chairman of the
House Financial Services Committee, told The Financial Times it would
be a “terrible mistake” for the Fed to adopt inflation
targeting to guide its interest rate decisions. Frank, whose
committee is the House counterpart of the Senate committee charged with
oversight of the US central bank, said such targeting “would come
at the expense of equal consideration of the [the Fed’s] other
main goal, that is employment.”
By that Frank meant inflation targeting could be used to keep inflation
down at the expense of full employment. His comments came as Fed
policymakers entered the final stages of a far-reaching strategy review
that included detailed debate over the merits of adopting an inflation
target. What Frank opposed was the prospect that the Fed would fight
inflation by keeping interest rate above that needed to produce low
unemployment.
Fed Chairman Bernanke believes that the central bank would be better
off with a relatively flexible inflation target – one that would
be achieved on average, rather than within a specific time frame,
giving maximum latitude to respond to exogenous output shocks. Critics
point out that this could lead to the Fed alternatively overshooting
and undershooting in the short term, creating undesirable volatility in
the market. This is because incoming economic data are known to be
unreliable and need subsequent revision.
Further, in order to make any such policy change, Bernanke would need
at least the tacit consent of key figures in Congress. Frank’s
unequivocal statements against inflation targeting as it impacts even
short-term unemployment suggest this consent will still be difficult to
secure even after generally favorable congressional hearings. Frank
told The Financial Times that Bernanke “has a statutory mandate
for stable prices and low unemployment. If you target one of them, and
not the other, it seems to me that will inevitably be favored.”
The reality could be that neither stable prices nor low unemployment
can be achieved by short-term flexible inflation targeting.
Advocates of an inflation target at the Fed say it is important to
distinguish between the relatively rigid form of targeting as used by
the Bank of England, and the relatively flexible form favored by
Bernanke. Frank, however, said he would not support even a flexible
target “without equal attention to unemployment
also.” What Frank wants is a low unemployment target to
link to a low inflation target. The fear is stagflation with high
unemployment accompanied by high inflation.
Inflation Expectation around the World
Inflation expectation has been rising everywhere in the world, driven
in part by rational expectation on the part of market participants.
Beyond price data on oil and food, US core inflation in the 2.2 - 2.3%
range since April 2006 has been above the central bank’s stated
comfort level of 1.6% to 1.9% for some time. Further, the “core
rate” is designed to sooth the financial markets and to distract
market participants from the reality of rising inflation. The core rate
does not exist anywhere in the real economy. It is a fictional notion
designed to disguise inflation to justify perpetual real negative
interest rates. And negative real interest rates have an upward spiral
effect on inflation trends.
And in the euro-zone, even a rising euro has not stopped inflation from
rising to 3% in November 2007, largely due to rising price of
dollar-denominated imports, such as oil, outpacing the rise in exchange
value of the euro. Evidence of second-round inflationary effects are
already visible, with Europeans workers, most vocal in France and
Germany, demanding wage increases to compensate for a loss of
purchasing power beyond the acceptable range of accepted inflation and
productivity targets. Member of the British police held a mass protest
over pay in central London on January 23, 2008, angered by a 2.5% pay
rise being backdated to only December 1, 2007 for member officers in
England, Wales and Northern Ireland.
Long-term inflation expectations in the euro-zone, as expressed by
interest rate futures, are running at nearly 2.5%, a robust 25 basis
points above official ECB target of “close to but below
2%”. Forecasters expect euro-zone inflation to slow in 2008 but
nobody is predicting that it will fall below target, let alone turn
negative for the rest of the year, particularly if the dollar continues
to decline in purchasing power. Responding to a declining dollar, oil
and other key commodities prices denominated in dollars can be expected
to rise in adjustment, causing inflationary pressure worldwide.
Global inflation outlook for 2008 does not justify an accommodating
monetary policy stance for any central bank. Risk of a recession in the
US looms larger by the day from the collapse of the debt bubble, yet
monetary policy is not an effective tool to prevent that prospect. A
debt bubble will eventually have to burst to allow overblown asset
prices to self-correct. If a central bank, as Greenspan claims, should
not and cannot intervene on asset prices on the way up, but starts to
target them on the way down, it fuels inflationary expectations. Low
interest rates had caused the price bubble; and resorting to lowering
interest rates to keep prices up after the bubble burst risks
hyperinflation.
If higher inflation to the level needed to sustain the expanding debt
bubble is tolerated, serious convulsions in global bond markets and the
foreign exchange market and serious disruption to the global flows of
funds can be expected. If high inflation is not tolerated, a violent
burst of the debt bubble may be the outcome. While the market pushes
the Fed to allow inflation to moderate price correction, it is far from
clear that the damage to the global economy from inflation will be less
than that from market price correction.
Inflation Expectations in Emerging markets
Measuring inflation expectations in emerging markets requires different
methods since competition for export market share has neutralized
wage-price spirals common for the developed economies. This is so
despite the fact that food and energy account for a much larger share
of total spending in poorer countries than in rich ones, making it
harder for workers to absorb price increases without demanding higher
wages to compensate. The core rate of inflation, excluding food and
energy, is moderate in most parts of the world and strikingly low in
some of the fastest-growing economies in the world, including Saudi
Arabia and even China, where core inflation was just 1.1% in October,
2007. Headline inflation in China was 6.5% in August, 2007 with food
prices leading the rise.
Food prices increase was exacerbated by an outbreak of porcine
reproductive and respiratory syndrome (“blue-ear” disease)
that has affected pig supplies, pushing the year-on-year increase in
meat and poultry product prices to 49% in August. 2007. Pork alone
accounts for around 4% of the basket used for the consumer price index,
so movements in its price have a direct feed-through into inflation.
The cost of eggs rose by 23.6% year on year in August, moderating from
a peak of 34.8% in June. Vegetable prices were up 22.5% over a year
ago. Aquatic-product prices are also gaining momentum. Food accounted
for 37% of the average total spending of a Chinese urban household in
2005.
The Fed and Global Stagflation
While inflation expectations remain locked at moderate rates, food and
energy prices will continue rising above-average rates because of
anticipated decline in the purchasing power of the dollar, causing
overall inflation to escalate globally as the global economy slows. The
Fed is betting on its aggressive rate cutting moves to turn 1970s-style
“stagflation” into mere inflation.
Until the end of 2007, many financial executives, market participants,
influential commentators and government policymakers had insisted
publicly that last summer’s credit squeeze would prove
short-lived and containable. Suddenly, in the course of a few weeks,
bankers and regulators have been forced to face reality and to admit
that the shock that began in August was merely the first sign of
widespread financial collapse that would take years to unwind.
Sharp Fall Off of Market Confidence
Market confidence fell abruptly off a cliff, with banks wary of lending
to each other while investors stop buying new securitized debt
instruments. Borrowing costs in the money markets rose dramatically to
put pressure on corporate borrowers, private equity acquisition and
commercial real estate finance.
Fear has spread to the entire global market, partly due to lack of
transparency behind the credit crisis that began in the US. Projected
losses continue to rise with no end in sight. The problem is made worse
by the self-inflicted loss of credibility on the part of top government
officials and leading financial executives.
For example, Fed Chairman Bernanke first suggested that the subprime
mortgage crisis would result in a manageable $50 billion in losses.
Less than three months later, he tripled the projected loss to $150
billion but still denying any threat of systemic contagion. Speaking
after the February 9 meeting of Group of Seven finance ministers, Peer
Steinbrück of Germany said the G7 now feared that write-offs of
losses on securities linked to US subprime mortgages could reach $400
billion, sharply higher than the $150 billion credit losses that the
Fed, Wall Street banks and other institutions have revealed in recent
weeks. The latest panic-stricken Fed interest rate cuts are telling
market participants to expect losses that could amount to trillions.
AIG, The world’s biggest insurance company by assets, sent
tremors through the markets on February 12 when the insurance company
raised its estimate of losses in October and November from insuring
mortgage-related instruments from about $1 billion to $5 billion.
AIG shares tumbled 11%, wiping $14 billion off its market value. AIG
has written $78 billion of credit default swaps on CDOs, which protect
the purchaser from a CDO’s failure to pay. The primary providers
of the hedges are bond insurers such as MBIA and Ambac, whose ability
to pay claims is causing deep anxiety in global markets. These have
written about $125 billion of protection on “senior
tranches” of CDOs. Catherine Seifert, analyst at Standard &
Poor’s, was quoted in the Financial Times that AIG would
“have an extremely difficult time regaining investor
confidence”.
How many times can public figures be shown wrong by subsequent
unfolding events before losing total credibility? The overused truism
is now flooding the media: that credibility is like virginity –
much easier to lose than to get it back. Like the resourceful pimp who
promotes the virgin-like freshness of his prostitute by claiming that
it is only her second sexual encounter, the “good
fundamentals” of the economy is touted over and over again by
influential public figures in the face of deepening systemic collapse
and dwindling confidence. Gratuitous advice that the market was
temporarily oversold and that every decline session presents a
“buying opportunity” continues to be standard pronouncement
by those who are in the position to know better.
The faith-based Larry Kudlow & Company program on CNBC, where
participants are asked to declare with solemn piety: “I believe
free market capitalism is the best route to prosperity” as an
article of faith, is increasing attracting viewers for its
entertainment value rather than for the quality of its analysis,
particularly when the host continues to repeat with a straight face his
tiresome mantra that goldilocks economy is alive and well in the face
of serious systemic financial disaster.
Losses Exceeding $1 Trillion
Back in the real world, Goldman Sachs analysts estimate that the total
final loss on US subprime mortgages would exceed 80% of its March 2007
face value of $1.3 trillion, even if the meltdown does not spread
throughout the $20 trillion total residential mortgage outstanding and
beyond the housing sector into commercial real estate and corporate
finance.
The bulk of this loss will ultimately be borne by pension funds whence
the average worker around the world expects to receive money to fund
his/her retirement needs. Market forces can resolve the financial
crisis with a sharp and quick price correction from bubble levels but
the politically sensitive Fed and Treasury are trying to engineering a
“soft landing” by extending the debt bubble, the penalty
for which would be a decade or more of stagflation. Pathetically,
supply-side market fundamentalists are clamoring for more government
bail out of the market, with “damn the economy” frenzy. It
is the equivalent of the God-fearing faithful asking the Devil for help
in easing the ordeal of faith.
Dollar Hegemony and Loose Monetary Policy
The benefits of a loose monetary policy are by now proving to be
dramatically short of what their advocates have claimed. A protracted
policy bias towards low interest rates led the economy into its current
debt quagmire, particularly when the unearned profit of the debt-driven
boom has gone to a select manipulating few, leaving the masses with
debts unsustainable by income. More low interest rates will perhaps
help the wayward financial institutions delay inevitable insolvency but
will not get the economy out of its debt crisis without pain. The
argument that subprime mortgages helped expand homeownership is false.
Such mortgages only put buyers into homes they cannot otherwise afford
by distorting the happy American dream into an unneeded financial
nightmare.
Easy money has been one of the most tempting monetary fallacies for all
governments all through civilization. It has brought down the mightiest
of empires, from Rome to dynastic China. But the one basic requirement
for sustaining the value of money is that it must not be easy to come
by without equivalent input of value. In the current international
architecture based on fiat money, governments of trading nations
justifies inflationary monetary policy with the need to lower currency
exchange rates to compete for market share in international trade.
Inflation is driven by global trade.
The Bernanke Fed seems to have followed Greenspan’s pattern of
adopting traditional gradualism only when interest rates are on the way
up to retrain inflation, but always abandoning gradualism on the way
down to stimulate growth, thus introducing a long-term structural bias
in favor of inflation. The Fed then frequently finds itself behind the
curve in fighting inflation expectation and overshooting to combat
deflation expectation. This unbalanced proclivity has contributed to
the long-term decline of the purchasing power of the dollar on top of
the fiscal and current account twin deficits. Yet the US has been the
privileged beneficiary of this easy fiat money fallacy through dollar
hegemony since 1971 when President Nixon abandoned the Bretton Woods
fixed exchange rate regime based on a gold-backed dollar. And this
fallacy of the benefits of easy fiat money is about to be exposed by
hard data for even the printer of the fiat dollar.
The Age of Worker Capitalism
There was a time in the past under industrial capitalism when in a
class war between capitalists and workers, moderate inflation could
help workers keep their jobs by keeping the economy expanding and make
it easier for them to pay off their debts to capitalists. But nowadays,
under finance capitalism when capital comes mostly not from
capitalists, but from enforced savings held by worker pension funds,
inflation robs workers of their retirement resources while stagflation
lays them off from their current jobs.
Capital has been manipulated as a notional value on which derivative
transactions are calculated and profit and loss are realized. Finance
capitalism, through income disparity condoned by supply-side ideology
of keeping profit for the rich in the name of capital formation and
letting the working poor be taken care of through trickling down from
the rich, has constructed a financial infrastructure that channel
profits to a few and assigns losses to the many. The inequity is
mind-boggling. At least the capitalists of industrial capitalism used
their own money. In finance capitalism, the retirement funds of workers
are manipulated by financiers to exploit workers.
A Flawed International Finance Architecture
In April 2002, the term dollar hegemony was put forth by me in Asia
Times on Line in a critical analysis of a post-Cold-War geopolitical
phenomenon in which the US dollar, a fiat currency, continues to assume
the status of primary reserve currency in the international finance
architecture that finances global trade. Architecture is an art the
aesthetics of which is based on moral goodness, of which the current
international finance architecture is visibly deficient.
Thus dollar hegemony is objectionable not only because the dollar, as a
fiat currency, usurps a role it does not deserve, thus distorting the
effects of trade, but also because its impact on the world community is
devoid of moral goodness, because it destroys the ability of sovereign
governments beside the US to use sovereign credit to finance the
development their domestic economies, and forces them to export to earn
dollar reserves to maintain the exchange value of their own currencies.
Exporting economies are forced to accumulate dollars that cannot be
spent domestically without severe monetary penalty and must reinvest
these dollars back into the dollar economy.
The Bretton Woods II Theory Fallacy
In 2003, economists Michael Dooley, David Folkerts-Landau and Peter
Garber proposed what has since become known as the Bretton Woods II
theory. The theory turns dollar hegemony from the destructive monetary
scam that it is into an assenting fantasy by applauding it as a happy
win-win arrangement in which newly industrialized countries peg their
currencies to the fiat dollar at an undervalued exchange rate in
pursuit of export-led growth; and in return, they reinvest their trade
surplus dollars back into the US, which acts as an economic anchor and
consumer of last resort. This warped theory fed the illusion that the
US trade deficit can be reversed by merely forcing trade surplus
partners to upward revalue their currencies. The 1985 Plaza Accord
succeeded in pushing the Japanese yen up against the dollar and threw
Japan into a two-decade-long recession without reversing the US trade
deficit.
By 2006, the US was running a current account deficit in excess of 6%
of its gross domestic product, a level that would normally be
considered excessive and unsustainable while the capital starved
exporting economies in Asia were holding large amounts of US debt. The
Bretton Woods II theory says that this state of affairs is both
desirable and sustainable, a dubious claim clearly disproved by facts
by now. There may still be some who argue that dollar hegemony is
desirable but no one can deny it is clearly unsustainable. If this
currency abuse is practiced by any other government, the International
Monetary Fund (IMF), a creation of the Bretton Woods regime, would
impose austere “conditionalities” on its fiscal budget to
restore the exchange value of the currency. With dollar hegemony, the
US, the nation with the longest continuous current account deficit in
history and the world largest debtor, is exempt from such IMF imposed
austerity discipline on its fiscal budget.
Dollar Hegemony Engenders US Protectionism
The net result of the injurious effects of dollar hegemony is the
emergence of anti-trade protectionism even within the US, the
supposedly lead beneficiary of the Bretton Woods II regime,
particularly the segment of the US population that has unevenly borne
the pain of free trade. For the exporting economies, there are growing
signs that political leaders are beginning to realize that export-led
growth is not the panacea that neoliberal market fundamentalism has
made it out to be. Exporting for dollars that cannot be invested at
home has left all exporting economies starved for capital for domestic
development, with serious disparity of income and wealth, and political
instability resulting from unbalance development. While much of
domestic politics in the exporting countries is distorted by uneven
power held by special interests of the export sector, a collapse in
global trade will shift the balance of political power back towards the
domestic sector.
The circular fund flow from US current account deficit back into US
capital account surplus appeared to have come to a sudden halt in the
summer of 2007. The US Treasury International Capital System (TICS)
data show a massive drop in net foreign purchases of US long-term
securities since the end of June, dropping from $99.9 billion to $19.5
billion in July and to a negative $70.6 billion in August, bouncing
back to a positive $26.4 billion in September. All the while, US
current account deficit has been running about $80 billion a month.
Dollar Hegemony Feeds the Debt Bubble
What dollar hegemony does over time is to feed the US debt bubble and
steadily weaken the value of the dollar while it hollows out the US
industrial core, as US policymakers in both the Clinton and Bush
administrations tirelessly assert that a strong dollar is the national
interest. Whenever the dollar debt bubble burst in the last two
decades, as it again did in August 2007, and the Fed had been forced
into the fad of a monetary easing mode, i.e. lowering dollar interest
rates not just temporarily but kept it low for long periods. The effect
has been to force the purchasing power of the dollar to fall which then
induced other central banks to let their currencies fall as well to
protect their competive export market shares and to preserve the value
of their dollar holdings in local currency terms. A competitive
currency devaluation war will eventually unravel dollar hegemony in a
disorderly fashion into a spiral of global hyperinflation. That
eventuality appears to be at hand in 2008.
The collapse of dollar hegemony can accelerate the emergence of an
Asian regional currency regime, along the lines of what happened in
Europe after the collapse of the Bretton Woods regime in 1971. There
has been a lot of talk for a long time about Asian monetary union, with
little progress so far. See my July 12, 2002 article on The case for an
Asian Monetary Fund in Asia Times on Line.
Prisoners Dilemma for Foreign Central Banks with Massive Dollar Holdings
The dollar’s fall in exchange value relative to the euro is
costly for all central banks holding large amounts of
dollar-denominated financial assets whose economy also imports from
euro-zone, even when dollar denominated commodities continue to
appreciate in price. By holding and continuing to accumulate large
amounts of dollars from trade surplus, these central banks have a
powerful incentive to ensure that their dollar holdings retain their
purchasing power and exchange value in relation to their own
currencies. Yet if these foreign central banks perceive the US Fed as
powerless to halt the fall of the dollar by its unwillingness to keep
dollar interest rate appropriately high, because the Fed prefers a
robust market to a strong economy, they would have an equally powerful
incentive to sell off their dollars while there is still a market for
them or to compete to buy hard assets that would cause prices to rise.
Both of these moves will lead to dollar hyperinflation.
This situation creates a well-known “prisoners’
dilemma” for central banks with massive dollar holdings.
Collectively, these central banks have a compelling incentive to hold
on to their dollars to avoid a massive sell off that hurts everyone, so
as to maintain the dollar’s value on world currency markets for
the common good. Yet individually, each central bank has an incentive
to sell dollars and diversify its holdings into other currencies or
hard asset before the market collapses from other central banks selling
ahead of the others to gain individual advantage. This fear of
defection from a common interest leads to a classic prisoners’
dilemma, and the risk that these dollar-holding central banks will
simultaneously try to diversify their currency portfolios poses the
greatest threat toward a run on the dollar. The Western oil companies
have been playing this game of the prisoners’ dilemma against
OPEC members for decades to induce individual producers to cheat for
advantage by selling more than its share of the allotted quota, causing
Saudi Arabia, the lead producer, to keep oil prices up by cutting its
own production below its allotted quota to minimize the effect of
individual defection. The Saudi’s role as swing producers held
the cartel together. The US, unlike Saudi Arabia, has thus far shown no
inclination of cutting down the production of fiat dollars.
The Triffin Dilemma of 1960
The Triffin dilemma, name after Belgian-American economist Robert
Triffin who first identified it in 1960, is the problem of fundamental
currency imbalances in the Bretton Woods regime. With dollars flowing
overseas through the Marshall Plan, US military spending and US
citizens buying foreign goods and US tourists spending aboard, the
amount of euro-dollars in circulation soon exceeded the amount of gold
backing them. By the early 1960s, an ounce of gold could be exchanged
for $40 in London, even though the official price in the US remained
$35 by law. This difference showed that the market knew the dollar was
overvalued and that time for gold-backed dollar was running out.
The solution was to reduce the amount of dollars in circulation by
cutting the US balance of payments deficit and raising dollar interest
rates to attract dollars back into the country. But these moves | | |
