A bad recipe for economic recovery
9 December 2010
Over the past two years, I have discussed several times in speeches and on this blog the origin of the economic crisis and the solutions to it. In April 2009, I said that there was one thing more dangerous than the crisis: the way we will react to it. If we intervene too much or in an inappropriate manner, we could very well aggravate and prolong the crisis. Unfortunately, I fear that this is what the world is doing now.
The situation has not really improved over the past couple of months. Several countries, including Greece and Ireland, have experienced major financial crises due to an unsustainable level of debt.
Since 2007, public spending has exploded everywhere. A scholar at the Brookings Institute, Eswar Prasad, has calculated that the level of debt of industrialized countries in relation to their overall economy has gone from 48% in 2007 to 71% in 2010, and could reach 85% in 2015.
At the same time, monetary policy continues to throw oil on the fire. We need to remember that the current crisis is the consequence of previous crises provoked by the Fed and other central banks around the world.
When they create too much money out of thin air and artificially reduce interest rates, they bring on artificial booms, which are necessarily followed by a crash. We had the high-tech boom at the end of the 1990s, followed by the crash in
2001. And then the real estate boom, followed by another crash beginning in 2007.
Each time, central banks inject massive quantities of new money in the economy to prevent the crisis. But all they manage to do is to create more instability.
In the United States, the Fed launched some weeks ago a new phase in what economists call “quantitative easing.” In simple terms, what this means is that it buys securities with newly created money.
The first phase, which injected 1700 billion dollars into the American economy, has not succeeded in spurring sustainable economic growth, nor in reducing unemployment. Instead of concluding that this type of measure did not work, they are now going to inject another 600 billion, while continuing to maintain interest rates at record low levels.
This monetary policy is now being criticized by more and more people, in the US as well as around the world. It should be obvious to everyone that printing money does not increase the quantity of goods and services and cannot make anybody richer.
This policy is the equivalent of a time bomb. For now, consumer price inflation stays relatively low because banks are keeping much of this new money in their reserves and not lending it. That does not prevent inflation in some areas. The prices of energy, metals and agricultural products are very much going up.
But at a certain point, the money kept in reserves will start circulating in the economy at large. When there is more money chasing the same number of goods, prices necessarily go up. We’re talking here not just about some more money, but about enormous amounts of money.
The Fed will then have two choices: either to let prices dangerously go up and the American dollar collapse; or else increase interest rates and take the surplus money out of the economy, which might provoke another crash.
Economics has taught us that to have sustainable growth, we need monetary stability and prudent economic policies that favour entrepreneurship and trade. But for many years now, western countries have tried on the contrary to produce wealth with more debt and more money created out of thin air. This is a recipe that has never worked and which may only prolong the crisis we are in.
We need to change direction, and the sooner the better.
Thanks for listening, and talk to you soon.