In the first part, a grim diagnosis of the international monetary system (IMS) under the dollar paradigm was established. Global competitive devaluations- ignited largely by the Federal Reserve's accommodative monetary policies- are undermining global economic stability. Consequently, stabilizing the IMS requires more disciplined monetary policies dictated by sound principles, instead of politically motivated zeals.
Central banks have resorted to expanding the money supply in order to spur domestic economic growth. Such printing of money, however, merely steals growth from the future without addressing the existing inherent anomalies of the system. By setting artificially low interest rates, central banks are creating illusionary perceptions of wealth, which inevitably lead to booms and "malinvestments", thus macroeconomic busts. When such central bank policies, characterized by cheap credit, are multiplied at the global level, solemn uncontrollable imbalances arise. Therefore, it is pivotal to understand that such undisciplined macroeconomic policies, or quantitative easing (QE) programs, are meant to delay essential and fundamental reforms to the IMS. Most importantly, loose monetary policies enable rent-seeking politicians to build political platforms on unsustainable fiscal programs, which are only possible through inflationary monetary policies. Evidently, the pursuit of a stable and efficient IMS is compromised due to reckless domestic political interests.
How can we take concrete steps towards a system of disciplined monetary policies? The inherent problem has been identified, but a more theoretical explanation is required. The adherents of the Austrian school of economics have developed a comprehensive theory of the business cycle, which explains how central banks' credit-expansion unbacked with real savings consistently generates boom-bust cycles. In practice, when the Federal Reserve uses the open market operation (OMO) to manipulate short-term interest rates, markets and agents pay close attention to what the Federal Reserve is doing or even just saying. Most importantly, when the Federal Reserve pumps $85bn to the economy every month by purchasing government bonds, investors and businesses gain access to excess liquidity. An image taken from the Federal Reserve database aptly illustrates this trend.
The private sector is interpreting that the economy has more potential to grow. Consequently, firms and businesses take out loans to expand production by increasing investments and/or employing people in order to supply the new level of demand. With increased demand for goods and services, companies need also more raw materials. Therefore, the suppliers of raw material are simultaneously expanding their production, which leads to further expansion of the suppliers' suppliers. As a result, the whole supply chain has falsely interpreted growth indicators and is exacerbating the cycle of malinvestments. When the purchasing power of consumers begins to decline due to higher prices and weakening currency, decreasing aggregate demand forces suppliers to also downsize production. As a consequence, businesses that have used excessive credit to expand production are now forced to cut-back on fixed costs. Unfortunately, often these cuts are felt by employees, whose working hours are cut or positions terminated.
As unemployment increases, government officials advocate for aggressive stimulus programs, which are masqueraded political tools and not economic principles. Even worse, government may deem certain industries or businesses "too big to fail" and pump additional liquidity to save these companies. Unfortunately one can't fight fire with massive amounts of kerosene. Inevitably, the economy must readjust by "cleansing" itself with austerity. However, austerity as a policy-tool is a political hara-kiri, thus politicians are by nature reluctant to admit the necessity of such painful readjustments. As a result, nominations to key economic positions are dictated by pure political interest and not sound monetary economic principles. The only argument politicians need to make is the one that starts the printing machine at the central bank in order to sponsor irresponsible, but politically profitable programs. Voters naturally are inclined to blame economic downswings on the greediness of the private sector, whilst politicians loudly exploit the band-wagon effect with raucous anti-business rhetoric.
Federal Reserve's commitment not to taper the QE yet is going to keep the game of musical chairs going with limited chairs. With virtually no discipline in monetary policy, the Federal Reserve with its new pro-stimulus Chairman is choosing to ignore Milton Friedman's profound statement:" inflation is everywhere and always a monetary phenomenon." With certainty, we can expect the next boom-bust cycle to be similar to the one prior to the crisis. Or even worse.
Author: Henri Erti
The views of the author do not necessarily represent the views of the Ludwig von Mises Institute-Europe.
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