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Have central bank and government reactions to the crisis created a large danger for the future?
Have central bank and government reactions to the crisis created a large danger for the future?
During the past several months, concerns have risen that the expansionary policies of the U.S. government and the Federal Reserve System to counter the present crisis are creating the danger of a substantial future inflation. Some speak even of a hyperinflation, that is, of a rate of inflation exceeding 50 percent per month. People believing in the latter scenario base their concerns on results I presented in Monetary Regimes and Inflation: History, Economic and Political Relationships, which shows that all hyperinflations were caused by huge government deficits. By analyzing many historical examples, I illustrated how hyperinflations resulted whenever 40 percent or more of government expenditures were financed by money creation. Since it is expected that about 42 percent of U.S. expenditures will be financed by credits this year, some fear the emergence of hyperinflation in the United States. Consequently we face the interesting question of whether a very high U.S. inflation with a corresponding fall of exchange rates has to be expected.
In discussing this question, let me state two facts which in my view cannot be denied: First, that the present crisis has been initiated by the Federal Reserve’s too expansionary monetary policies after the bursting of the New Economy Bubble. Second, that the Fed and the U.S. government embarked on even more expansionary policies to fight the present crisis; indeed, their policies constitute an experiment on a scale which has never been seen before in the history of fighting crises.
Though the Fed initiated the crisis, we should not forget that it would never have taken such a dramatic course, which hurt the real economy, were there not other well-known defects in the financial system.
Let me turn to the first point. In a mistaken fear of deflation, the Fed lowered its interest rate to 1 percent and increased the monetary base by about 39 percent from 2000 to 2006 after the bursting of the New Economy Bubble. In doing so it encouraged an incredible credit expansion by the financial sector and thus allowed the subsequent asset bubble. Later, it helped to pierce the bubble by raising its interest rate step by step above 5 percent and by strongly reducing the growth of the monetary base. Though the Fed thus initiated the crisis, we should not forget that it would never have taken such a dramatic course, which hurt the real economy, were there not other well-known defects in the financial system such as:
Before taking up the second point, namely the possible consequences of measures taken by Fed and U.S. government to counter the crisis, let me stress that crises cannot be prevented in a decentralized and innovative market economy. It may be possible to mitigate them by adequate reforms or even to prevent one or the other. But that is the best result one can hope for.
Crises cannot be prevented in a decentralized and innovative market economy.
This can be demonstrated by looking at crises from two different perspectives. By analyzing historical events, Charles Kindleberger has shown in Manias, Panics and Crashes that 29 financial crises occurred from 1720 to 1975. This means that, on average, each decade experiences an unpredictable crisis, though very strong crises are rather rare. For instance, besides the 1929 crisis, another in 1873 was severe, lasting about six to seven years and hitting the real economy from Europe to the United States, Argentina, and Australia. Apart from the historical evidence for the inevitability of crises, mathematical chaos theory has demonstrated that systems characterized by non-linear feedbacks can be hit by unpredictable fluctuations. And a decentralized market economy has quite a number of such feedbacks—for instance, changing expectations of consumers and producers, fluctuations in the volume of net investments, governmental interventions, central bank policies, and the reaction of prices to unpredictable innovations.
A Danger of Hyperinflation?
Let us turn now to the second point, whether grave dangers loom because of the measures taken by central banks and governments to fight the present crisis. Is there even a danger of hyperinflation in the United States? Let us first consider the facts. Central banks led by the Fed have indeed lowered their interest rates to nearly zero percent. The monetary base of the Fed has grown by about 99 percent within one year from the end of July 2008; and this following a substantial increase already since the end of 2008. Even the Swiss National Bank increased its monetary base by 112.5 percent from the end of 2008 to the end of May of 2009. The growth of the monetary base in the euro zone looks more modest, with 68 percent since the end of 2007. But even this smaller increase has never been experienced in monetary history except in countries suffering from high inflation.
Government finances, too, have worsened dramatically because of the measures taken to fight the crisis. The U.S. deficit rose from 2.9 percent of Gross Domestic Product (GDP) in 2007 to 8 percent in the fourth quarter of 2008; for 2009 a deficit of 10.2 percent is expected. This implies that the indebtedness of the United States will reach 73.2 percent of GDP in this year. In Great Britain the deficit grew from 2.7 percent to 5.4 percent in 2008, whereas one of 9.3 percent is foreseen for 2009. In the euro zone, the deficit of member states increased from 3.5 percent in the fourth quarter of 2007 to 9.3 percent of GDP by the end of 2008.
Even if all the measures may help to mitigate and to shorten the crisis, which is probable, it has to be asked whether lowering interest rates and expanding the monetary base will not bring about even worse developments in the future.
But were these measures not justified because of the dramatic situation and the dangers threatening in the crisis? It is difficult to form a judgement because of the extraordinary extent of the measures and because we do not know the further course of the crisis. Certainly some steps like those taken to save General Motors were not warranted. But even if all the measures may help mitigate and shorten the crisis, which is probable, it has to be asked whether lowering interest rates and expanding the monetary base—measures similar to those which have already initiated the present crisis—will not bring about even worse developments in the future.
Speaking to members of the board of central banks, one is assured that they are technically able to reduce the enlarged monetary base and to increase their interest rates to normal levels any time. This is probably true. Asking, however, whether they will be able to do so given the political and psychological pressures to be expected when timely measures to prevent inflation by rising interest rates have to be taken, the answer is again “yes.” But this seems to be rather doubtful since such adjustments would have to be made at a time when tender growth has just set in and when unemployment may still be rising. A stiffening of monetary policies to fight inflation needs about two years before results can be observed. It is thus not surprising that former board members of central banks and well-informed economists are much more skeptical concerning the chances of increasing interest rates and reducing the monetary base in time.
It is thus probable that in the future we will have to face a mistaken policy’s bad consequences. But what are the fundamental mistakes of this policy? To understand the underlying problems we have to remember a mostly forgotten important function of financial institutions in a decentralized market economy. In such a system it is one of their tasks to coordinate the savings of consumers (including obligatory ones for health and unemployment insurance) with the net investment of non-financial business firms and governments. In real terms this corresponds to a reallocation of factors of production from producing consumer goods to the production of means of production with the consequence that more and new goods can be produced in the future. Savings by consumers transferred as additional means to producers lead to a reduction in the demand for consumption goods and allow productive firms to increase their investments.
In a mistaken fear of deflation, the Fed lowered its interest rate to 1 percent and increased the monetary base by about 39 percent from 2000 to 2006 after the bursting of the New Economy Bubble.
In this process the real interest rate is determined by the impatience to consume and the greater productivity of more roundabout production processes (or expressed otherwise, the marginal productivity of real capital). The resulting “natural“ real rate of interest can change to a minor degree, but should, judging from the non-inflationary environment of the gold standard in developed countries before 1914, be around 3 to 4 percent. This means that if central banks lower the nominal rate of interest below the natural rate, they send the wrong signal to producers, including builders and purchasers of houses. They are motivated to indebt themselves to initiate additional investments and to enter production processes which would be unprofitable at interest rates from 3 to 4 percent. Consequently, not all of these investment decisions can be executed since not enough real factors of production are put at their disposal by the real savings of households.
In real terms, net investment must always equal savings. As a consequence, there remain only two ways to bring this equality about if nominal interest rates are too low and are disturbing this relationship. Either the central bank increases interest rates again—in this case, the net investments initiated are no longer profitable and have to be interrupted, as happened with the housing crisis in the United States—or the central bank leaves interest rates at their too low level, resulting in inflationary developments that cannot be avoided. The use of means of production for goods consumed by households is forcibly reduced since the purchasing power of their incomes and the value of their nominal assets are reduced. In both ways, or by some intermediate combination of them, the equality of savings and net investments is restored.
Measures taken by monetary and fiscal policies neglecting these real relationships are bound to fail, as already stressed by the Swedish economist Knut Wicksell in his Geldzins und Gueterpreise (Interest and Prices) in 1898. This means that central banks and especially the Fed are now confronted by a huge dilemma—huge because of the very dimension of financial support unknown in history, as illustrated by the figures presented above. And this dilemma is increased by the fact that high budget deficits of governments have to be financed. If expectations of households and firms become positive, another sizable asset bubble has to be expected because of the vast liquidity created. And inflation will follow the bubble if the Fed does not act speedily and strongly to reduce the monetary base and to increase the interest rate to normal levels. But such a policy may lead to another crisis and recession. On the other hand, if the Fed does act too late and not strongly enough, inflation cannot be prevented.
A stiffening of monetary policies to fight inflation needs about two years before results can be observed.
An escape from this dilemma seems only to be possible if the change to positive expectations and the rise of production follows a slow and continuous development, so that enough time is available to slowly increase interest rates and slowly reduce the monetary base and government budget deficits. But this path is not available in case of a rapid recovery. For then the danger of a sizable inflation is a real one.
But does this mean that inflation may evolve into a hyperinflation in the United States? I believe not. Though it is true that budget deficits with government expenditures covered by 40 percent or more through credits have historically led to hyperinflation, it has been stressed in Monetary Regimes and Inflation that it is not only the size of these credits but also their composition that is important. This is noted in the book thus: “It will be demonstrated by looking at 12 hyperinflations that they have all been caused by the financing of huge budget deficits through money creation“ (p. 70 ). This expresses the fact that only credit extended directly or indirectly by the monetary authorities to the government leads to the creation of money, that is, an increase of the monetary base. This is not true for borrowings taken up in the capital markets if they are not resold to the Fed. Looking from this perspective at the U.S. deficit, by far not all of the credits borrowed by the government were financed by the Fed. According to preliminary and rough estimates, not 40 percent but “only“ about 13 percent of U.S. expenditures are presently financed this way. Moreover, in discussing this problem it has to be taken into account that about two-thirds of dollar bills are estimated to circulate abroad. This—together with the fact that incredibly huge holdings of dollar assets are owned especially by the central banks of China, India, and the Gulf States—may pose other and later dangers. But these dangers will be, except for a return of the dollar bills and a purchase of foreign-owned dollar assets by the Fed, of a different nature. Inflation may rise more or less strongly during the next years, but there is presently no danger of a hyperinflation in the United States.
Peter Bernholz is professor emeritus at Basel University, Switzerland. His work focuses on monetary economics, real capital theory, and public choice. He is a member of the Academic Advisory Board of the German Minister of Economics.
Image by Darren Wamboldt/Bergman Group.
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