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Professor Steve H. Hanke is the author of the Monetary Misjudgments and Malfeasance, a Cato Journal, Vol.31, No. 3 (2011): pp. 473-484. According to Hanke, the United States policy has been characterized by monetary misjudgments and malfeasance. In spite of the fact that there were clear signs of the impeding economic crisis, the Federal Reserve officials and their counterparts in Europe were unable to alleviate the economic crisis that took place in 2008-09.
To make the matters even worse, their corrective measures turned the crisis into a panic. According to Professor Hanke, the Fed officials were mainly responsible for creating the demand bubbles (especially the market-specific ones) that disrupted the relative markets prices. In addition, both the Fed officials and their counterparts in Europe compelled commercial banks to raise their capital-asset ratios as a safety measure.
For example, the Bank for International Settlements (based in Switzerland) increased the capital-asset ratio from 4% to 7% based on the bank’s risk-weighted assets. It further imposed an extra 2% surcharge in addition to the 7% requirement for largest commercial banks. The justification for this move was that commercial banks would be safer and stronger if they were heavily capitalized.
On the contrary, this move distorted the money supply metrics and weakened economic growth. The money balances of commercial banks were effectively been wiped out. According to Professor Hanke, commercial banks were forced to shrink their asset bases in order to comply with the new regulation. As a result, the deposit liabilities of commercial banks’ declined significantly thereby wiping out money balances.
Statistics for Economics
The Federal Reserve is mainly responsible for creating market-specific demand bubbles in the US for a long time. Prior to the Lehman Brothers’ demise in 2008, the Federal Reserve not only generated aggregate demand bubble but also initiated a number of market-oriented bubbles. The Fed was in a good position to alleviate market-specific bubbles (witnessed in the commodity, equity and housing markets) by monitoring price volatility in the markets (such as adjustments in the aggregate consumer price index).
Nonetheless, the Federal Reserves officials have persistently refused to take any blame for generating market-specific bubbles that led to the economic crisis in 2008. As a matter of fact, the Federal Reserve officials have proposed that commercial banks must raise their capital-asset ratios in order to stabilize their operations and prevent a similar crisis from recurring (Hanke 473).
Aggregate demand bubble occurs when the Fed’s negligence permits aggregate demand to rise too fast. In other words, an aggregate demand is created when nominal final sales to buyers in the United States surpass nominal growth rate (consistent with modest inflation) by a large amount.
During the two-decade reign of Bernanke and Greenspan at the Fed, the nominal final sales rose at a 5.2% annual trend rate. This pattern reflected an inflation rate of 2.2% and real sales of 3%. Nonetheless, the annual trend rate has revealed a number of deviations. The first one started soon after Alan Greenspan was appointed the chairman of the Federal Reserve.
Following the stock market crash in October 1987, the Federal Reserve released more money into the market thereby creating an aggregate demand bubble. As a result, the nominal finals sales rose by 7.5% (above the trend rate) in the following year (Hanke 474).
It is worthy to note that the Federal Reserve was mainly responsible for initiating the 2008-09 aggregate demand bubble that led to the economic crisis. This led to the Federal Reserve’s preferred inflation targets-energy prices, absent food prices and consumer price index- increasing at modest rates.
For instance, the inflation rate grew by 12.5% between 2003 and 2008 period. Although the Federal Reserve’s inflation rate did not indicate any problems, unexpected changes in key relative prices were in the making.
For example, there was a surge in the housing prices (which increased by 45% between 2003 and 2006). In addition, share prices increased steadily by 66% in 2003 and reached its peak in 2008 (Hanke 475).
The most remarkable price increments were apparent in the commodity market. According to the Commodity Research Bureau’s index, prices of commodities grew by 91.8% between 2003 (first quarter) and 2008 (second quarter).
This remarkable increase was mainly attributed to a weak dollar (which declined by 30.4% during the same period) as well as the ensuing liquidity cycles. A number of financial markets experts believe that the surge in the commodity prices was as a result of the decline in the value of the greenback.
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For instance, the devaluation in the value of dollar precipitated a surge in commodity prices between 2002 and 2008. In addition, the prices for crude oil grew by 51% while the price for rice rose by 55.4% (Hanke 476).
The comparative rise in the housing prices was an obvious sign that prices were deviating from the fundamental laws. For example, during the first decade of the 21st century, the demand for housing in the United States was approximately 1.4 million units per annum.
This figure includes acquisitions of newly constructed houses as well as the refurbishment of over 290, 000 units per annum that were destroyed by floods and fire. Throughout the bubble years (2002-2006), housing buyers were about two million per annum.
This number increased given that an extra 490,000 units of were being created every year. In reality, the prices for the new housing units should have been declining during this period. On the contrary, this was not the case as the prices grew by 45%. The Federal Reserves officials failed to spot the imminent housing bubble and take counteractive measures (Hanke 477).
Following this incident, both the Federal Reserve and banking institutions engaged in the blame game as to who was responsible for the 2008-09 economic crises. The Federal Reserve officials claimed that banking institutions were undercapitalized and hence too hazardous and risky. Consequently, the Bank for International Settlements (based in Switzerland) issued new Basel III capital guidelines.
These new rules were expected to raise the capital requirements of banks from the current level of 4% to 7% on the basis of their risk-weighted assets. In addition, the Bank for International Settlements imposed an extra 2.5% on top of the 7% obligation for banking institutions that were perceived as too huge to fail.
However, these new requirements are not even enough for some financial regulators. For example, the Swiss National Bank plans to enforce a mega-high 19% capital requirement on both Credit Suisse and UBS. In the US, Federal Reserve officials have also advocated for a higher capital-asset ratios for large banks (Hanke 479).
The Federal Reserves and other financial regulators have successfully imposed high capital requirements on commercial banks. Since the inception of 2008-09 financial crises, US banks have been compelled to raise their capital-asset ratios in expectation of Basel III.
The Federal Reserve has applauded this move arguing that a higher capital-asset ratio will make the commercial banks safer and stronger. However, some experts believe this is not a wise decision. They argue that commercial banks can raise their capital-asset ratios by either issuing new bank equity or by reducing their assets.
If the commercial banks reduce their assets, the deposit liabilities will shrink and money balances will be wiped out. In other words, the Federal Reserve’s drive to raise the capital-assets ratios of commercial banks in order to make them stronger has had a negative impact on money balances.
This move has dented the liquidity and asset prices of commercial banks (Hanke 480). Commercial banks can also raise their capital-asset ratio by issuing new equity. However, this method also destroys money balances.
For instance, when shareholders procure newly issued bank equity, they use bank deposits to acquire new shares. As a result, this phenomenon reduces commercial banks’ deposit liabilities as well as their money balances (Hanke 481).
The decision by the Federal Reserve to force commercial banks to raise their capital-asset ratios during the 2008-09 financial crises was undoubtedly a great mistake. For example, the Bank for International Settlements (based in Switzerland) issued new Basel III capital guidelines. These new rules were intended to raise the capital-asset ratios of banks from 4% to 7% on the basis of their risk-weighted assets.
In addition, the Bank for International Settlements imposed an extra 2.5% on top of the 7% obligation for banking institutions that were perceived as too huge to fail. Commercial banks were thus forced to raise their capital base by either issuing new shares or reducing their asset base in order to comply with the new directives. Although this move probably made commercial banks stronger for a short period, it distorted money supply metrics and compromised economic growth.
Hanke H. Steve. Monetary Misjudgments and Malfeasance. Cato Journal 31.3 (2011): 473-484.