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Welcome To The G-8 World Of Illusion

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The Group of Eight (G-8) finance ministers in their meeting in Lecce, Italy, last weekend announced that their economies had stabilized and as a result they were preparing for their "exit strategies" from their prevailing unorthodox monetary and fiscal policies:

We discussed the need to prepare appropriate strategies for unwinding the extraordinary policy measures taken to respond to the crisis once the recovery is assured ... These "exit strategies" which may vary from country to country are essential to promote a sustainable recovery over the long term. We have taken forceful and coordinated action to stabilize the financial sector and provide stimulus to restore economic growth and there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence, but the situation remains uncertain and significant risks remain to economic and financial stability.

Do they know something the rest of us don't? Let's look at general economic conditions in the G-8. As a result of excessive money expansion and largely negative interest rates, they have fallen into the grips of the worst financial crisis in the post-World War II era.

Economic indicators in crisis-stricken G-8 members have been deteriorating since August 2007. Banks had to be bailed out at a fiscal cost of trillions of dollars and are still saddled with additional trillions of dollars in toxic assets. Real growth in gross domestic product (GDP) has become negative almost everywhere, and unemployment will probably continue to increase into next year. Industrial production has fallen sharply. Exports have plummeted. Consumers are defaulting at high rates on their debt. Real incomes of workers have been dramatically 2eroded and impoverishment is growing.

Recently, commodity prices have once again come under renewed pressure and exchange-rate volatility is again on the rise. Yet ignoring these general indicators, these G-8 policymakers have rushed to announce that their economies have stabilized, recovery is well under way and they are preparing to bury this phase of their policies and move on!

What optimism! What cheerleaders! Their optimism was based on their make-believe recovery indicators as clearly indicated in their communique, namely a recovery of stock markets, a decline in interest rate spreads, and improved business and consumer confidence, and one omitted factor - the Mediterranean mood in southern Italy, good food and wonderful views. The G-8 ministers' perception of stabilization could be as imaginary as the indicators that inspired their imagination (lest we be misunderstood, the food and the views are not imaginary!).

Only because of unorthodox monetary policy, in the form of zero and near zero interest rates and unlimited money printing by G-8 central banks, they now have an illusory and distorted picture of their economies. Stock prices have been rising rapidly at a time when economic growth was largely negative and the rate of return on capital was negative. The huge liquidity introduced by central banks was destined to find its way to the stock markets and create a speculative bubble in stock prices, even though dividends were negligible or non-existent.

Similarly, near-zero interest rates and direct lending by central banks to risky customers have contributed to dramatically narrow interest rate spreads because the risk was directly assumed by central banks on loans extended to subprime borrowers.

The consumer confidence indicator was another imaginary and non-transparent indicator. No one knows who were the consumers surveyed? Whether they were unemployed, homeless, heavily indebted and bankrupt, or wealthy consumers with permanent and well paying jobs such as medical doctors, government officials, or Wall Street financiers? Was the survey taken in the spring time when people were cheerful or in winter and snowy day when people were less cheerful?

If central banks are pushing trillions of dollars in consumer loans at negligible interest rates, why should consumers not feel more confident than before? The unorthodox printing of money has indeed produced a situation where prices have been rising (the broader measure as opposed to the convenient "core" rate that excludes energy and food) rapidly and real economy has been declining. Such a situation used to be called "stagflation".

The rise in stock, oil, and asset prices and consumer confidence should not be fallaciously considered as a sign of stabilization or even recovery. It could a pure effect of money "helicoptering" from the sky by major reserve banks and zero or near zero interest rates. It is as costless to create distorted economic and financial indicators as it is to print money.

Even their notion of "stabilization" is illusory. They give no definition or any indication of what they consider as stabilization. At the micro level, stabilization means the market is in equilibrium with no pressure on either demand or supply. At the macro level, stabilization means that the government has put in place an economic program capable of re-establishing internal and external balances with no unsustainable budget or external deficits, and prices that are stable in most markets, including consumer prices, asset markets and exchange rates.

With fiscal deficits breaking record levels, external accounts largely in deficits, exchange rates highly volatile, and money expanding at excessive speed, it is illusory and optimistic to pretend that the economy has been stabilized. Without stable macroeconomic policies, it is nonsense to conclude that economic stabilization has been achieved.

The US, the leading member of G-8, has for about a decade consistently followed overly expansionary fiscal and monetary policies, finally destabilizing the global financial system and the world economy. With the outbreak of the crisis in August 2007, the US decided to even accentuate the same policies that led to the instability in the first place. Accordingly, the US Fed cut interest rates to nearly zero and undertook large money injections through a number of unusual lending facilities.

The monetary base has expanded from US$834 billion in May 2008 to $1,806 billion in May 2009, an increase of about 117%. Such an expansion has never occurred in US monetary history. Consequently, the reserves of the US banking system rose from $45 billion in May 2008 to $933 billion in May 2009, an incredible multiple of 21, while the banking system's level of excess reserves went up by an even larger multiple, from $2 billion to $877 billion in May 2009.

Banks are in a position to initiate unlimited credit expansion given such mountainous level of reserves. Under such circumstances, how could one say that the US economy is stable? Bernanke's monetary policy has no comparable historical precedent and its impact cannot be judged on the basis of previous experience. If banks act to reduce their bank reserves to the normal level of $45 billion, then ensuing credit expansion could be of the order of $15 trillion or more. The implications of such expansion could be dramatically inflationary and could push external deficits and dollar exchange rates to an unprecedented deterioration. The rate of inflation could become into the high two-digit level. Are these stable economic conditions?

The US fiscal position is projected at record levels of about 13% of GDP for the coming years. Again, we have little historical parallel and it would be difficult to evaluate its adverse impact on growth, employment and the external account. The current account (external) deficit could reach record levels. However, foreigners, even if they were willing to finance such deficits, may not have the available reserves.

Inevitably, much of the deficit may to be financed domestically through domestic borrowing or monetization. The inflationary consequences again could be serious. Hence, with such fiscal policy in place, is it not a little farfetched to speak of a stable US economy?

Stabilization policies secured prosperity for the US during 1982-2000. The prospects for the US to adopt stabilization policies in the years ahead are almost nil as the present administration is willing to run unsustainable fiscal deficits, and the Federal Reserve chairman, Ben Bernanke, seems only willing to turn the tap in one direction, open.

Anyway, a Fed attempt to tighten monetary policy may be torpedoed by the US Treasury. For instance, if the Fed decides to contract the money base to its May 2008 level, it has to sell about $1 trillion in government paper. This would compete with the US Treasury, which intends to sell several trillions in government securities in order to finance its budgetary commitments. Interest rates will explode, increasing the cost of financing the US deficit, and the US fiscal deficits would reach default levels.

It would appear that the G-8 not only believes that unlimited money creation and record fiscal deficits would lead to stabilization, they seem to also believe that these policies would lead to an assured recovery. If these same policies were responsible for the crisis, it would be difficult to see how they could also lead to recovery?

Not many countries, if any, have succeeded in restoring economic growth under a combination of highly expansionary fiscal and monetary policies. These policies deplete savings and constrain investment, impose a huge inflation tax on workers and fixed-income consumers, and operate a redistribution of wealth to speculators and borrowers. Very low interest rates squeeze bank incomes and discourage lending - and they in turn expose banks to ruin when interest rates explode. If the G-8 plans to exit from these extraordinary policies once recovery is achieved, it may never reach the exit.

The G-8 strategy has taken extraordinary measures to boost demand in form of fiscal stimulus and unorthodox monetary policy. The inflationary effect of these policies had been played down all along. Although oil prices went up by 60% and food commodities by 25% during the short time span of April-May 2009, G-8 policymakers have totally ignored recent inflationary tensions and their effects on real growth.

For instance, in the US, the prices of some major food products have doubled, tripled, and even quadrupled in the last four years and continue to rise at a fast rate under the impact of money and fiscal expansion. Yet, US policymakers expect headline inflation to decrease by one-half percent in 2009 and increase by 1% in 2010. Inflation will squeeze real demand and consequently depress employment.

The G8 has not considered stimulating supply instead of demand. The world economy suffers from a lack of supply. Oil supply is severely constrained and cannot be expanded beyond 85 million barrels per day to meet unlimited demand. Food supply is severely constrained and needs to be augmented in order to solve shortages in face of growing demand. Increasing supplies of energy and food and other basic commodities are essential for growth. Economic recovery could be best achieved through stable fiscal and money policies and not through boom and bust policies.

Stable? Maybe the one that the horse has bolted from, but most certainly not G-8 economy.

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So in the belief that things have stabilised, they want to unwind QE and put up interest rates?

Err, I'm OK with that...


*reads second half of article*

Err, what do they want?


Edited by Timm

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confusion for the masses

It's almost as if they want to prevent anyone making any rational financial decisions.

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