By W.A Wijewardena –
Bernanke’s historic speech at LSE
Ben Bernanke, the outgoing Chairman of the US Federal Reserve or simply the Fed, has delivered a historic speech at the London School of Economics, popularly known as LSE, just four years ago in 2009 at the height of the global financial and economic crisis and two years after the Fed started its now infamous monetary easing which was later renamed quantitative easing or QE. Since Bernanke is to relinquish his post at the Fed at the end of January, 2014, it is opportune to look at his speech closely to assess the nature of the legacy he is leaving behind for his successors to grapple with.
LSE has been inviting eminent scholars to deliver its Stamp Memorial Oration, an event established by it in honour of Josiah Charles Stamp, an alumnus and former Governor of LSE. The 2009 Stamp Memorial Oration had been delivered by Ben Bernanke, Chairman of the Fed on an apt title “The Crisis and the Policy Response”, the crisis here referring to the 2007-8 global financial crisis (available here ).
Josiah Stamp: An economy needs time for fixing
Stamp has been noted for his outspokenness as an economist and in many BBC Radio discussions held in 1930s, he had had a number of confrontations with the leading British economist of the day, John Maynard Keynes. In one discussion, when Keynes had remarked that the existence of prolonged unemployment was an admission of failure of policy and a hopeless and inexcusable breakdown of the economic machine, Stamp had objected to him saying that one cannot expect to put a complex machine into right position within a few days after it has gone wrong (available here ). Bernanke had six years to put the crashing US economy back to right position and that period is not the type of ‘few days’ within which a policy maker is unable to fix an ailing economy as opined by Stamp.
The hindsight evaluation of Bernanke’s policy package will enable one to judge what central banks can do and what central banks should not try to do.
Attempt to speed up recovery through Fed’s intervention
Bernanke says that the proximate reason for the financial crisis of 2007-8 has been the burst of the housing bubble in USA, now attributed to the wrong low interest rate policy pursued by his predecessor, Alan Greenspan, to super-stimulate the economic growth through central bank policies. Bernanke admits in 2009 that the localised crisis soon became a global crisis, again a consequence of the high linkage which the US economy and its financial system have with the rest of the world. The heavy toll it took in terms of loss of output, employment and wealth throughout the globe has therefore been substantial. Though the global economy was expected to recover on its own in due course, the timing and the speed of recovery were not to the liking of the world community and therefore it was felt necessary that governments should intervene to speed up the recovery process. Ironically, this was an opinion expressed by Keynes in conversation with Stamp in 1930 in a BBC Radio Programme, referred to above, at which Stamp is reported to have rebuked Keynes. Hence, according to Bernanke, the Fed sought to intervene in the economy through its monetary policy tools.
The loosening of monetary policy to fix the US economy
The monetary policy toolkit used by the Fed consisted of a number of related policy actions. First, interest rates in the US economy were brought down to near zero level within a matter of some 10 months in the hope that people would consume more and businesses will invest more at low interest rates. Then, the provision of money to the private sector by the Fed through financial institutions was enhanced to boost the credit markets in the midst of a general drying up of savings due to low interest rates. Third, aggressive communication methods were used to convince the public and the businesses that the low interest rates were to prevail for a long time and therefore they need not reverse their consumption and investment activities, respectively. Fourth, the lender of last resort window of the Fed was converted to that of first resort by regularly pumping funds to the system by buying numerous securities from the market. This last action resulted in a massive increase in the money printed by the Fed, also known as Base Money, from around $ 800 billion in 2008 to $ 3900 billion by September 2013.
One mistake leading to another mistake
The underlying assumption of this type of policy intervention by the Fed, and also by other central banks, is that central banks, or more specifically the central bank created-money, can boost economic growth. The reasoning goes as follows: Economic growth comes from the production of a bigger output and continued production of such a bigger output is dependent on the consumers’ ability to buy that output on the one hand and producers’ ability to produce more and more output on the other. When central banks reduce interest rates artificially to low levels, it is believed that consumers make a hard choice in favour of consumption and producers in favour of investments. So, central banks seek to kill two birds with one stone by reducing interest rates. But one unintended consequence of the reduction of interest rates is the drying up of the savings flows since people now get a low rate of return for their savings. When the savings flow declines, banks are unable to lend money to businessmen though interest rates have become lower. To increase the funds available for lending, central banks start printing money and supplying to the financial institutions. It drives the interest rates further down and dries up the savings flows further. Thus, central banks get caught in a vicious trap: They have to keep on pumping more and more central bank-printed money to the financial system in order to keep it alive. Thus, one mistake made by a central bank leads to the making of a series of mistakes.
This wisdom of central banks, based on what the influential British economist John Maynard Keynes prescribed in mid 1930s to help a developed country economy to come out of a temporary economic recession, had been questioned long before Ben Bernanke tried it in the recent past. The founding Governor of the Central Bank of Sri Lanka, John Exter, in his report submitted to the Government of Ceylon in 1949 on the establishment of a central bank in Ceylon, had warned against the blind adoption of Keynesian type of policies to an open economy. He has said that “In a country like Ceylon, however which is very dependent on imports in which about half the productive resources are devoted to export, and which is chronically short of capital equipment, such policies tend to raise domestic prices without producing an adequate response in domestic output. Instead, the higher domestic incomes would stimulate the consumption of imported goods and precipitate serious balance of payments difficulties” (pp 26-7 of the Exter Report).
Goh Keng Swee: Using central bank credit is an invitation to disaster
A similar rejection of Keynesian type of money printing policies for achieving economic growth has been made by the Singapore’s new government in mid 1960s. As explained by its first Minister of Finance, Goh Keng Swee, in an article titled “Why a Currency Board” which he wrote to the 25th Anniversary Commemoration Volume of the Currency Board of Singapore in 1992 (Prudence at the Helm), the leaders of Singapore known as the old guard had not believed that Keynesian type policies could serve as Singapore’s guide to economic well-being. He explains the rationale for this as follows: “Our economy was and is both small and open. Financing budget deficits through central bank credit creation appeared to us as an invitation to disaster. There is no effective way of exchange control in an open trading economy like ours to deal with inevitable balance of payments troubles” (p 33).
Proving Exter and Swee correct
The prediction of these two practical economists that central bank-printed money in an open economy will create balance of payments difficulties by creating a larger trade deficit has come true in the US in the recent past. Sri Lanka too, contrary to the sound advice by John Exter, followed the same policy throughout its post independence period and has not been spared. Singapore, on the other hand, has been consistent in its policy throughout and therefore has been able to avoid the predicted pitfall.
Bernanke’s critics had warned him of the impending disaster
This outcome has not been unknown to Bernanke and the Fed. In his Stamp Oration in 2009, he has referred to the criticisms made by some economists on the undue expansion of the base money in USA through the quantitative easing programme of the Fed. He admits that through QE, the Fed is effectively printing money which is inflationary. Since the increase in base money has been faster – faster than the rate of absorption by US banks – its conversion into the ultimate money stock by banks through multiple deposit and credit creation has somewhat lagged. Bernanke refers here to what economists call the ‘money multiplier’ in the financial system – the number of times banks can create new money by using one unit of base money created by the Fed. Historically, this has been 5 in USA meaning that when the Fed creates one dollar, banks will ultimately create additional 5 dollars. If this had been the case, QE at the rate of $ 85 billion per month would have created an uncontrollable monetary expansion leading to very high inflation. But Bernanke says that banks have chosen to keep a large amount of the money created by the Fed in idle form ‘in most cases on deposits with the Fed’. This negates the purpose of introducing QE, namely, to promote bank credit and through bank credit, increase in consumption and investment. As a result, the Fed has now been caught in a vicious trap through it is a blessing in disguise from the point of the US citizens.
Creation of many problems trying to solve one problem
The US money multiplier which amounted to 5 in 2008 is now less than even 1, meaning that when the Fed prints and issues one dollar, the eventual increase in money supply through additional bank credit is less than one dollar. Thus, for the first time, the base money has been bigger than the narrow money stock in USA. It is a blessing in disguise since the Fed’s QE has not led to monetary expansion and consequential high inflation. As a result, the US citizens now experience the historically lowest inflation in the country which is less than 1 percent per annum. However, it has inflicted the US economy with a number of macroeconomic ailments: Low inflation, high trade deficit, low economic growth, high unemployment and pressure on the dollar to fall in the international markets. Thus, it appears that Bernanke, having tried to solve one problem, has created so many problems in the US economy.
Decline in US money multiplier is a blessing in disguise
The US has been able to finance its high trade deficit because the US dollar is accepted as a reserve currency for use in international transactions and investment by other nations. Historically, about a two third of the world’s reserves are kept in US dollars. Hence, some of the dollars printed by the Fed are likely to be circulated outside USA forever without creating inflation in the home economy. Thus, US citizens have been able to extract resources from the rest of the world just by printing dollars. However, this has a limit and the US will hit that limit when the rest of the world refuses to accept the dollar as a reserve currency due to domestic inflation arising from higher money creation in the past. Right now, new money is just absorbed into idle excess reserves; but when the banks resume their lending programmes and when the money multiplier rises to its historical highs, the US money supply will jump up several-fold – more than the US annual output. At that level, inflation becomes uncontrollable and the US economy will be faced with a different type of macroeconomic ailments.
US has no choice but to give up QE
These ailments take the form of rising interest rates in order to curb inflationary pressures, ending the current QE since the Fed will not be able to continue with liquidity pumping at the same rate and a massive shrink of consumption by US citizens and investment by businesses. It will lead to a curtailment of the output in USA; it will also have adverse impact on several other countries which are linked to the US economy and its financial system.
Beware the hot money recipients
When the US interest rates go up – it has already moved up as shown by the sudden jump in the benchmark 10 year US Treasuries rate from below 1 percent to 3 percent recently – all the hot money that had flown into Asia and Latin America in search of high interest incomes is likely to return to USA. The casualties in Asia are Sri Lanka, India, Thailand and Indonesia which had enjoyed a temporary surge in foreign exchange flows into their respective economies helping them to keep a strong exchange rate despite domestic economic problems. Sri Lanka is particularly in a critical situation since about a two third of its foreign exchange reserves are made up of borrowed money and even if only a small segment of that money leaves the country, the consequential reserve loss will be fatal to both the balance of payments and the exchange rate.
US policy reversal will affect Sri Lanka too
The increase in the US interest rates will also have adverse impact on the growth prospects of China which at present supplies a bulk of manufactured products to that country and other countries such as Malaysia, Thailand and the Philippines that supply inputs to China. Sri Lanka too faces a risk since about a fourth of its exports are directed to the US. These countries will therefore have to put risk mitigation mechanisms in place.
Central banks can promote growth: An exaggerated view
The mistake being made by many central banks is the belief that money is sufficient cause to generate economic growth. This is an exaggerated view of the role of a central bank in an economy. It has been refuted very correctly by Goh Keng Swee in the article referred to above. This experienced practical economist has said that “The way to better life was through hard work, first in schools, then in universities and polytechnics and then on the job in the work place. Diligence, education and skills will create wealth, not central bank credit” (p 33). It is unfortunate that Bernanke and many other central bank governors have not read Swee. Thus, the legacy which Bernanke is to leave behind is going to be unpalatable not only to USA but also to the rest of the world.
*W.A Wijewardena –Formerly Deputy Governor of the Central Bank of Sri Lanka and presently Visiting Lecturer at PIM, University of Sri Jayewardenepura, Asian Institute of Technology, Bangkok and Naresuan University, Thailand. He can be reached at firstname.lastname@example.org