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Destabilizing Us Must Change Course

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Destabilizing US must change course

In his testimony before the budget committee of the US House of Representatives, on June 3, 2009, Federal Reserve chairman Ben Bernanke expressed conflicting views regarding the record US fiscal deficits over 2009-2012.

He restated his long standing view that "Final demand should be supported by fiscal and monetary stimulus", thus undermining the private sector's role to generate employment and income. Then, unexpectedly, he contradicted this view as well as his unconditional support for fiscal stimulus, by noting that the US fiscal deficits in the years ahead will rise to such prohibitive levels that US public debt could be pushed to non-manageable levels, especially if interest rates spike. He hinted at some departure from his past views on the dangerous level of fiscal imbalances: "Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs."

Undoubtedly, US fiscal deficits during 2009-2012 are projected to rise to dangerous levels, exceeding 12% of gross domestic product (GDP). If these deficits are to be financed by domestic borrowing, then there will be little or no domestic savings left to meet the investment needs of the private sector, and the borrowing needs of cities and municipalities. in this case, economic growth will plummet.

If financed by foreign savings, then private investment will be dragged down in the rest of the world and further constrain world economic growth. If financed through monetization, which seems increasingly inevitable, as low interest rates on US debt and a depreciating US dollar will deter cheap foreign financing, inflation will be ruinous for creditors and fixed income recipients and with ominous implications for long-term US economic recovery.

In view of sizeable US debt and its interest expense, the US Treasury would compel the Fed to keep interest rates low, undermining real savings and economic growth and keeping inflation high and the dollar in a death spiral. The road ahead is anything but rosy.

Unfortunately, Bernanke has not appreciated the need to restrain money policy and has seemingly ignored the previous bouts of cheap money policy, which have all ended in financial crisis, and social and economic decay. He has remained insensitive to the damage his (and that of his predecessor as Fed chairman, Alan Greenspan) policy has brought to the US and the global economies.

Ironically, he has described the damage quite succinctly himself: "The US economy has contracted sharply since last fall, with real gross domestic product having dropped at an average annual rate of about 6% during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008."

Notwithstanding the magnitude of the drop of real GDP, Bernanke eluded his audience by stating a fact of utmost gravity without any explanation. While a deceleration of economic growth to a low positive or even a low negative rate is worrisome and a symptom of sub-par economic management, a significant negative growth rate should be of major concern. The only explanation for such significant negative growth is Bernanke-cum-Greenspan decade-long aggressive monetary policy in form of negative real interest rates and unlimited money injection.

One of the giants of economics, Irving Fisher (1933), after reviewing all causes for large drops in GDP, determined that, barring war, a big drop in GDP could only arise from over-indebtedness. Besides an unsustainable credit-to-GDP ratio, Bernanke (and Greenspan) unleashed speculation in commodity markets that crippled the US and world economies. Speculation pushed food prices to prohibitive levels in vulnerable countries and even in the US, where the number of people living on food stamps stood at 34 million in May 2009 and climbing. Aggressive money policy has created overwhelming distortions between asset and commodity prices, the level of indebtedness, and the wage-income structure in the economy.

Negative economic growth means the "cake" has become smaller, and therefore in terms of per capita income, people have a lower standard of living than before, with impoverishment raising its ugly head in some of the more unfortunate parts of the country. These conditions mean that capital has a negative return and the rate of profit is negative in the economy. The rate of economic growth has realigned with the negative real interest rates forced upon the US economy during the past decade.

There is a close relation between interest rates, rate of profit, productivity of capital and the rate of economic growth. Depressing real interest rates to a negative range through a decade-long cheap money policy has caused misallocation of resources in the economy and brought the return to capital and the rate of economic growth into a negative range.

Yet, stock prices, albeit a leading indicator, have gone up sharply in spite of a deepening recession. For instance, the Dow Index appreciated by 35% during March 9-June 5 this year. Such incredible appreciation at a time real GDP growth was negative, the rate of unemployment at 9.4% and with little sign of a significant recovery (even though the Dow Index is a leading indicator) is a total disconnect between financial markets and the real economy, and the powerful result of Bernanke's policy in creating distortions and speculation.

Liquidity injection by the Fed has found its way into speculative markets such as stock and commodity markets and pushed asset prices into another speculative boom.

As in previous testimony, Bernanke has dismissed the presence of any inflation or inflationary threat, saying: "In this environment, we anticipate that inflation will remain low. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008." Yet, gas prices shot up by 30% and food prices rose by 15% during April-June 2009. Noting that average US consumers spend much of their incomes on buying fuel and food, such inflation will drag consumer spending down and weigh on economic growth, as it did in 2007-2008.

No responsible central banker should ignore such two-digit inflation in food and gas prices and maintain that there is no inflation. US central bankers have long decided to ignore the effect of monetary policy on energy and food inflation and asset prices (for example, housing prices) and to pay attention only to core inflation, irrespective of the vicissitudes of the excluded inflation and its powerful adverse effect on economic growth.

The gap between financial investors and Bernanke was irreconcilable. While investors, rightly expecting inflation, were fleeing dollar assets and the falling dollar, Bernanke was anticipating no inflation in a highly unstable policy environment. Even though Bernanke has always played down inflation, his deliberate policy at the behest of his supporters was to re-inflate the US economy out of over-indebtedness and push housing and stock prices to high levels to prevent impending bankruptcies.

By reducing interest rates to zero and expanding money supply at over 15% a year, Bernanke wanted to achieve high inflation for asset and commodity prices and a lower dollar to alleviate the cost of US public and private debt. This policy has created exchange rate instability and high inflation in the world economy. The more the Fed attempts to inflate, the more other central bankers are forced to do the same; the inflation spiral could become competitive, fed by competitive devaluations and massive liquidity expansion.

Bernanke plays down the fact that oil prices could be as inflammable as oil. The ravages of high oil prices have been evident. With a view to stabilize oil prices and help the world economic recovery, the Organization of Petroleum Exporting Countries has decided to maintain its output level in face of falling oil demand. Unfortunately, as in the past, Bernanke has pushed oil prices up and up through his relentless zero interest rate, a depreciating US dollar, and unlimited money printing. Oil prices are again on the march upwards. When oil prices rose to $147 a barrel in July 2008, the US Congress was mad at oil companies, summoned their officials for hearings, and never saw the link between Bernanke's policy and oil price inflammation. Equally disturbing is the total silence of Congress and the administration in the face of oil and food price inflation.

Over the next four years, the US economy will face a combination of record fiscal deficits and unsafe money policy that will debase the US currency. Such policy has so far depressed the US economy, cut real incomes, and caused heightened uncertainties. Real savings will be absorbed by gigantic fiscal deficits and will be totally discouraged by zero interest rates. Hence, private investment will drop to low levels that would not enable the economy to recover and create badly needed jobs. In such an environment, world-wide inflation could accelerate, food and energy supply could dwindle, and economic growth could be further derailed.

The media and policy makers started to "see" the end of the tunnel and confidently projected US economic recovery for the second half of 2009. Unfortunately, with looming and irreversible US fiscal deficits and Bernanke's merciless money debasing, the order of the day will be speculation and uncertainty.

Economic recovery will require massive real investment and a stable macroeconomic environment. Financial markets have lost confidence in the soundness of US policies and expect a possible collapse of the dollar and growing US debt difficulties, namely, that US debt service is forced to decline in real terms through accelerating dollar depreciation and inflation. These expectations will not favor economic recovery. The most likely scenario will be a depressed economy for as long as the Fed continues its policy stance of the past decade.

Bernanke admitted in his speech that the US has to make difficult choices and had to rein in its runaway fiscal deficits. The administration and Congress have to admit that they have to make a much less difficult choice: renounce unorthodox money policy. The idea of turning a recession into a boom overnight through money printing should be disbanded. The US economy is trapped in a vicious circle: cheap money policy, bankruptcies, inflation and recession, and fiscal expansion.

The US Fed has long been seen as a source of instability in the US economy. Its discretionary power and deliberate role in fueling unsafe credit expansion and asset bubbles have cost the US two years of negative growth and excessive social and economic dislocation.

The Group of 20 policy of transplanting Bernanke's aggressive monetary policy to the rest of the world is yet another mistake. World leaders should realize that the exit from the present financial crisis, brought about as a natural consequence of cheap money policy, is not through further monetary chaos. Without reinforcing money discipline, the world economy will in time suffer high inflation and economic decline.

The world cannot afford the severe consequences of present financial instability, the devastation of unruly reserve central banks, excessive taxation of the poor and free wealth redistribution in favor of speculators and borrowers. The world economy has to achieve price stability and restore prudent monetary policy before it can restore significant sustained growth.

Loss of faith in the dollar is a given.

How does Bernanke fiddle the numbers from here on in, and will the world ever gain back confidence in the crumbling American empire?

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