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Before taking up the second point, namely the possible consequences of measures taken by Fed and US government to counter the crisis, let me stress that crises cannot be prevented in an 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. This can be demonstrated by looking at the occurrence of crises from two different perspectives. By analyzing historical events Charles Kindleberger has shown in his book Manias, Panics and Crises of (1978) that 29 financial crises occurred from 1720 to 1975. This means that on average each decade experienced an unpredictable crisis, though very strong crises are rather rare. For instance, besides that of 1929 another one of 1873 has been severe, lasting about six to seven years and hitting the real economy from Europe to the USA, Argentina and Australia. Apart from this 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.
We turn now to the second point, whether grave dangers are looming because of the measures taken by central banks and governments to fight the present crisis. 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 279% until June 16, 2010 since the end of 2007.
The recent announcement of further “Quantitative Easing” is likely to further worsen the situation.
20, Even the Swiss National Bank increased its monetary base by 115% from the end of 2007 to the end of 2009. The growth of the monetary base in the Euro Area looks more modest with 64% since the end of 2007 until June 2010. But even this smaller increase has never been experienced in monetary history except in countries suffering from high inflation, And since the Greek crisis the ECB has begun to buy bad Greek government assets and thus to presumably further increase its monetary base.
Government finances, too, have worsened dramatically because of the measures taken to fight the crisis. The US deficit rose from 2.9% of Gross Domestic Product (GDP) in 2007 to 8% in the fourth quarter of 2008; for 2009 a deficit of 10.2% was expected. This implies that the indebtedness of the USA would have reached 73.2% of GDP in that year. During fiscal year 2009 40.16% of Federal expenditures were covered by credits, and in fiscal year 2010 even 41.46%. In Great Britain the deficit grew from 2.7% to 5.4% in 2008, whereas one of 9.3% was foreseen for 2009. In the Euro Area the deficit of member states increased from 3.5% in the fourth quarter of 2007 to 9.3% of GDP in the end of 2008. The debt reached 78.6% of GDP in the end of 2009, with Italy at 115.8 and Greece at 115.1 leading the development. The budgetary crisis of Greece following in 2010, and similar, but less severe developments in Portugal and Spain have demonstrated that weaker economies have used the low interest rates to indebt themselves beyond any reasonable limits.
But were the measures taken by the Fed and other central banks as well as those of the respective governments not justified because of the dramatic situation and the dangers threatening in the crisis? It is difficult to form a judgment because of the extraordinary extent of the measures and because we do not know the further course of the crisis. Speaking to members of the board of central banks one is assured that they are technically able to reduce the blown up 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 they would have already to occur at a time when tender growth has just set in and when unemployment may still be rising. For a stiffening of monetary policies to fight inflation has to set in about two years before results can be observed because of the usual time lags. It is thus not surprising that former board members of central banks and well-informed economists are much more skeptical concerning the chances to increase interest rates and to reduce the monetary base in time to prevent substantially higher rates of inflation.
It is thus probable that we have to face some bad consequences of a mistaken policy in the future. Already Sir Walter Bagehot (1873) recommended to the Bank of England to lend freely in a crisis drying up the money markets among financial institutions, a policy which was rightly followed by the central banks during the recent crisis. But Bagehot also recommended to do this at a penalty interest rate and only to institutions who were solvent judged from the value of their assets in normal times. And Wicksell warned already in 1898 against the dangers implied by lowering the interest rate below its natural rate in a discretionary monetary regime.
3. Did the Financial Crisis and the Measures Taken against it Undermine the Independence of Central Banks?
Unfortunately we have to answer the question whether the financial crisis undermined the independence of central banks with a clear „yes“. The most recent example is the dramatic policy change of the ECB in the beginning of May 2010, which clearly violated the requirements of the Maastricht Treaty not to lend to member governments, if not legally – this is an issue still debated – then at least in spirit. Even worse, the ECB bought Greek government junk assets in the capital markets above market valuation, and there is a definite danger that all such outstanding assets will finally land with the IMF and the ECB. Moreover, the ECB also accepted bad Greek assets as security for its lending to Greek banks. According to reliable though not official information only three of the members of the decisive body, among them the two German representatives voted against this new policy.
It is perhaps not surprising that similar policies were already pursued by the Fed for quite some time before the ECB embarked on its new policies. For instance it had bought until June 17, 2009
665.7 billion dollars of mortgage-backed securities. Until June 16 of 2010 it increased these dubious assets to an amount of 1121 billion. In a note it mentions concerning them „Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Current face value of the securities, which is the remaining Principal balance of the underlying mortgages.“ (Federal Reserve, H.4.1, Fn. 4). This means of course that these assets are guaranteed now by the federal government. To these dubious assets others under fanciful names like Maiden, Talf, AIA Aurora LLC and Alico Holdings LLC, which were sponsored by governmental measures have to be added.
Even the Swiss National Bank has been led by the UBS crisis to lend at the end of 2009 21 billion francs to the Stabilization Fund created to take over dubious assets from the UBS.
4. What are the Forces Threatening the Independence of Central Banks?
In the early 1970s the Hungarian Janos Kornai (1971) observed that it was characteristic for communist countries that no binding budget constraints for firms and other organizations were present. Obviously this fact contributed to the bad performance of these so-called planned economies. Now it seems to follow from public choice analysis that politicians and governments in democratic market economies are also not in favor of binding budget constraints. They try to push them outward to be more able to grant favors to their constituencies or to interest groups in order to win the next elections. And increases in taxes are certainly less favored for these purposes than to soften budget constraints by incurring debts in money and capital markets. But unfortunately for the intentions of politicians there exist limits concerning, the amount of debts they can heap up. First, the interest to be paid on them swallows an ever bigger part of government revenues. And second, creditors may become suspicious when observing a rising indebtedness and call for higher risk premiums on interest to be paid.
At this critical moment establishing control of central banks may be helpful for government politicians. And at this juncture a decisive difference between gold standard and discretionary monetary regimes becomes important. To make this clear let us look at the balance sheet of the Swiss National Bank (SNB, Bilanz 2009) as a least suspicious example.
Simplified Balance Sheet of the SNB, End of 2009 Billion Swiss Francs
Before the end of the gold standard the SNB like other central banks could become illiquid or even move into bankruptcy by being no longer able to convert the banknotes it had issued at demand at the fixed gold parity into gold coins or bullion. It thus was confronted by a limiting budget constraint hindering it to over-issue its notes or to grant too much credit to banks. This is no longer true with the discretionary paper money of pure credit money standards which we enjoy nowadays. Even if the value of its assets would fall, let's say, because of the credit granted to the Stabilization Fund and losses in the value of foreign exchange reserves denominated in euros and dollars, below that of its debts, no liquidity crisis or bankruptcy would arise. For the 45 billion francs in banknotes are now inconvertible, that is they are in fact non-interest-bearing credits by the public to the central bank with endless maturity. The same is true for the current claims in francs of domestic and foreign banks, since they can always be paid back by the SNB with its own freshly printed banknotes. A liquidity or bankruptcy problem can only arise if the assets denominated in foreign money had a smaller value than its obligations in these currencies.
The consequences of this analysis mean nothing else than that apart from assets and liabilities in foreign currencies there exists no longer any budget constraint for central banks. And internationally the leading central banks have also moved some distance to push out the latter budget restrictions by granting each other swap facilities in the tens of billions. As public choice economists we should thus not be surprised that politicians are now very keen to get control of central banks and to undermine their independence. For if they succeed they are themselves no longer limited by those uncomfortable budget constraints.
5. Are there any Escapes from the Undermining of Monetary Stability by Governments?
Carl Schmitt, a well-known German professor of public and constitutional law, who was an early adherent of the Nazi movement, once pointed out that
which can be translated as: „Sovereign is he who decides on the state of emergency“ that is when laws can be changed and even constitutional rules be suspended because of the emergency declared.
Thus the real power in a state is revealed by answering the question who has the power to suspend
and perhaps even to change the constitution in an emergency. Actually two sub-questions emerge:
First, who has the right or the power to declare an emergency. Second, who has the right or power to take the actions foreseen by or to be interpreted into the constitution.
It is my hypothesis that constitutions binding the hands of politicians and governments in normal times can be undermined in times of emergency. Indeed, there exists overwhelming support for this hypothesis in terms of empirical evidence. I have already mentioned above the abolishment of the gold standard because of World War I and the Great Depression. During the latter not only Britain abolished the gold standard, but president Roosevelt decided to devalue the gold parity in terms of dollars and even to forbid the possession of gold by American citizens. Even Switzerland which stuck to the old gold parity together with the other members of the gold bloc led by France until the devaluation in 1936, abolished the gold convertibility of its currency. And this though Article 39,6