Who is paying for the beer?


By Hossein Askari and Noureddine Krichene
Asia Times
Dec 17, 2009


Charles Kindelberger, the late international economist, recounted (195 the parable of an American tourist who went to Mexico. On arrival, the tourist changed his dime into pesos on the parallel foreign exchange market. He drank a few beers. Later, he converted back his remaining pesos into a dime at a Mexican bank at the official rate. He returned to the parallel market and converted his dime into pesos. He drank a few more beers, then converted leftover pesos into a dime at a Mexican bank at the official rate. He kept repeating this practice and enjoying free beers during his Mexican holiday. On the last day of his vacation, he converted his pesos into a dime at the official market and returned home. Kindelberger’s question: who paid for the beer? Let's see if we have an answer before we are done.

Throughout history, financial crises have been invariably caused by monetary factors. Since Irving Fisher (1933) advanced the theory of over-indebtedness, that is, excessive credit expansion, followed by deflation of asset prices and general bankruptcies, central banks have had an ominous role in engineering systemic financial instability and economic dislocation.

The Great Depression of 1929-35 was caused by deliberate policy of low interest rates by the US Federal Reserve in support of an overvalued UK pound sterling. In turn, very low interest rates fueled a credit boom, encouraging speculation and setting off speculative asset bubbles. The collapse of the stock market in 1929, combined with conversion of foreign exchange into gold by some major central banks, precipitated the Great Depression.

The Fed has been at the center of the financial crisis that broke out in August 2007. By setting the federal funds rate at 1% during 2003-2004, the Fed fueled, not one but many bubbles - housing, stocks, commodities, including oil and gold, and in currencies. As suggested by Fisher, these bubbles were nurtured by an over-expansion of credit that pushed liquidity toward speculative activities.

As confirmed by the response of the Group of 20 countries to the current crisis, central banks are not primarily interested in the stability of the banking system. Their chief objective is clearly stated by Fed chairman Ben Bernanke: achieve maximum employment. They hardly mention, let alone stress, the systemic stability of the banking system. Central banks never moved to arrest the exploding credit boom, the over-leveraging or addressing the asset bubbles. They proclaim perfect price stability even in the context of rising commodity and food prices and exchange-rate volatility. They only cite core inflation, thus excluding food and energy price inflation, and asset price changes.

Even when crude oil prices hit US$147 per barrel, food prices rose to riot level, and the US dollar collapsed, core inflation in the US remained below 1%. A price index restricted to one group of commodities cannot serve as a measure of inflation. Boasting perfect price stability at a time of high commodity and asset price inflation (and exchange-rate volatility) has been a key factor in misleading policymakers.

Credit markets have been frequently analyzed in a dichotomic fashion: a prime market and a subprime market. Hyman Minsky proposed a dichotomy that encompassed hedge units and Ponzi units. The prime market (or hedge units) has the cash flow for servicing its debt. The subprime market is composed of speculators who, by definition, are interested only in price movements, and Ponzi borrowers who have no savings for servicing the interest and principal of their debt and borrow with the intent of default. Besides increasing the rate of expansion of credit, a credit boom changes the composition of credit toward the subprime markets.

The prime market has a limited demand for credit, which is determined by the Real Bill Doctrine, which implies that credit is influenced by real economic activity and is re-paid once cash flow from sales materializes. Subprime markets' demand for credit is not related to economic activity. Credit can be expanded only by pushing liquidity to subprime markets that have unlimited capacity for absorbing loans essentially for speculation and consumption purposes. Hedge funds, mutual funds, and equity funds had a leverage ratio that could exceed 100 times their equity capital. A fast rise of speculative asset prices such as stock, housing, and commodity prices is a reflection of higher credit to subprime markets. John Maynard Keynes (1936) made a similar dichotomy for demand for money, namely demand for money for transaction purposes and demand for money for speculative purposes. When demand for money for speculation rises, it translates into higher asset prices.

Aggregate demand could be dichotomized into two components; one is generated by income flows in the economy and the other created artificially through pushing loans to Ponzi borrowers. A credit boom, by creating empty money that has no backing in terms of savings and pushing loans to subprime markets, expands aggregate demand and stimulates output and imports. When the financial crisis erupts, general bankruptcy sets in, and credit contracts, the credit-supported demand of the sub-prime market vanishes forever.

Many sectors, such as auto and housing industries, find themselves with excessive production capacity that was based on extraordinary debt-supported demand by the subprime sector and are doomed to incur losses and lay-offs. Demand for investment drops and the multiplier and accelerator work in reverse, causing an economic recession. Moreover, the credit boom causes immense distortions and misallocations in the economy and a huge redistribution of wealth to Ponzi borrowers. It causes the price of food and basic commodities to rise to levels that force reduction in real quantities demanded and in curtailing demand for non-essentials in favor of essential goods and services.

Wary of the dangers of credit expansion and mindful of the composition and quality of credit, the proponents of quantity theory proposed a fixed rule for money supply. Based on the quantity equation MV=PT, where M is money supply, V is money velocity, P general and all-inclusive price level, and T volume of real and financial transactions. The fixed rule requires money supply to rise at a rate equal to the rate of increase of T augmented by a desired rate of long-term inflation at 1-2%.

This relationship, while advocated by monetarists such as Fisher, Milton Friedman, and Maurice Allais, was rejected by central bankers and most academics who favor a discretionary rule that allows the central bank to control interest rates with a view to boosting employment. The most favored discretionary rule is the Taylor rule, which sets interest rates in relation to the rate of unemployment.

The difference between the two rules is fundamental. While the fixed rule takes money as a medium of exchange and a store of value and relies on Say's law and the price mechanism for adjustment to ensure allocation of resources, the discretionary rule sets interest rates, introduces distortions in the price mechanism, diverts credit to speculators and Ponzi borrowers, and allows the monetary base and credit to grow to any level possible, as these aggregates are of little relevance for the central bank whose objective is employment. Hence, the level and composition of credit turns out to have little relevance for central banks that are pursuing interest-rate targeting.

Data for Japan (click here for Table 1) shows that private credit raced upward at 11.5%-12.5% per year prior to the breakout of the financial crisis in 1992, far in excess of a fixed rule that would have implied a safe rate of 5%-6%. The private credit/GDP (gross domestic product) ratio, at 187.4%, was among the highest in the world. The credit boom was supported deliberately by the central bank through a very low real interest rate and a rapid increase in the monetary base. Noticeably, the credit boom boosted aggregated demand as reflected by real GDP growth rate at 4.2%-4.6% a year; it created price distortions and shown by consumer price inflation of 6.6% a year, and a large component of credit-fueled speculation in real and financial assets, as featured by an appreciation of share prices at 15% a year.

The response to the crisis was to re-inflate the way out of debt. The central bank deliberately set interest rates near zero and expanded the money base at 9.6%, far in excess of a safe rule of 2%. The re-inflationary policy caused the private credit/GDP ratio to rise to more unsustainable level at 209.3%. In line with Fisher's theory (1933), share prices fell at 2.2% a year, reflecting the speculative nature of the asset bubble prior to the crisis. The re-inflationary policy has intensified distortions, undermined economic growth, with real GDP growth rate falling to 0.4% a year, and created more speculation in form of yen carry trade - speculators borrow yen at near zero interest rate and buy high-yield assets denominated in other currencies, enjoying big rewards in the arbitrage process. Japan became a classical case of the impotence of money policy, with devastating effects on growth, and its unjust taxation and wealth redistribution.

The US learned nothing from the Japanese financial crisis (click here for Table 2). The Fed set interest rates very low and pushed credit to expand freely. Thanks to financialization, the private credit/GDP ratio rose to 193.7% compared with 86.2% in 1961-70, among the highest in the world, at about 12% a year, exceeding the rate implied by a fixed rule at 5%-6% a year. A large part of the increase was destined to subprime markets, as the investment/GDP ratio was falling and the real GDP growth rate fell from 4.2% a year in 1961-70 to 2.8% a year prior to the 2008 crisis.

Besides undermining growth, the expansion of credit in favor of speculation and sub-prime component has turned the external current account from a surplus into a monumental deficit. The credit boom set off intense speculation as a large part of the credit markets became dominated by thousands of non-regulated money market funds that have the pseudo financial role of collecting savings and engaging in overleveraged speculative schemes.

The fast expansion of speculative credit jerked up the price of shares, gold, crude oil, and food prices. These prices had shown considerable stability before the credit boom gained momentum.

The US response to the crisis was a replay of the Japanese experience, namely re-inflating the way out of debt through unorthodox money policy, amazingly large fiscal deficits, and mountainous bailouts. The aim was to prevent any decline in speculative asset prices. As did the Japanese, the Fed set interest rates at near zero. It expanded its money base at 106.7% a year, and engaged in gigantic empty money-creation schemes aimed at pushing directly trillions of dollars to sub-prime market borrowers.

Banks had to be bailed out at a colossal cost, shifting losses to taxpayers, workers, pensioners, and homeless. Bernanke's aggressive money policy fired up commodity prices and pushed the US economy deep into recession and rising unemployment.

Near-zero interest rate and unlimited liquidity have intensified further distortions in the US economy and wealth redistribution. The carry trade in dollars has expanded very fast, yielding gains for speculators who borrow at zero cost in dollars and invest in higher yielding assets in other currencies.

Could the US crisis and post-crisis performance resemble that of Japan, namely a drawn out economic recession and more financial disorders? In view of an excessively high debt burden, failing banks, misguided policies, and intensifying speculation and distortions, the US economy may experience a long agony similar to Japan's.

The Fed has been printing money and fanning loans at near zero interest rates. Speculators and borrowers have been enjoying gains and wealth. Japan's central bank has been doing the same thing since financial crisis broke out in 1992. The question is: who is paying for free gains by speculators (and bankers) and subprime borrowers? Let's see if we have an answer?

In the case of the American tourist in Mexico, the answer was obvious: the US banks that lent to Mexico lost their shirt. In the case of the US, the cost is paid by bailouts, high energy and food inflation, fiscal deficits, and China, which holds largest share of US foreign liabilities? Knowing the inevitable, the Chinese have repeatedly expressed concern about the Fed's aggressive policy and record US fiscal deficits.

The Japanese and US experience illustrate the devastating impact of financialization, the sprawling expansion of speculative funds and finance, and misguided monetary policy. In spite of the impotence of money policy and the inability of banks to continue fanning loans to subprime markets with a certainty of loss, central banks have chosen to intensify empty money creation, reduce interest rates to near zero, and redistribute wealth in favor of speculators.

New lending facilities were put in place by the Fed to lend directly to subprime markets, ignoring the potential risk of such lending. Experience has shown time and time again that many central banks never reverse course irrespective of the disastrous effects of their policies, as shown by erosion of growth capacity in both the US and Japan.

Some countries such as South Korea, Norway and Thailand suffered financial crises by allowing credit and speculation to expand to a crisis point. However, these countries dismissed re-inflationary policies and their severe distortions and accepted a recession following monetary tightening; consequently, they were able to return to growth in a stable monetary framework with a diminished credit for speculation.

The US, along with many other countries, chose to remedy the disastrous effects of loose monetary policy by further monetary expansion and intensifying distortions and capital erosion with rapidly rising unemployment, while enriching bankers beyond their wildest dreams. It has been business as usual!

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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