$12.8 trillion and counting

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Bloomberg News estimates $12.8 trillion (U.S.) as the amount of financial support already given by the U.S. authorities to its banking system. So far, this led to no meaningful improvement in credit conditions, or bank lending.

The man overseeing this stupendous bailout -- $12.8 trillion represents about 90 per cent of the value of U.S. production last year -- is Federal Reserve Board Chairman Ben Bernanke, the U.S. central banker.

Suppose he does not know what he is doing?

Bernanke talks like a monetarist, a school of economics that is best described as believing in capitalist utopia. Markets are efficient and self-regulating. Prices are flexible, so that sellers and buyers can always find each other.

Monetarists link the supply of money to the price level. If there is too much money, prices go up faster than production, creating inflation. If there is not enough money, prices go down, slowing production and deflation is the result.

For Bernanke, the origins of the current financial meltdown are to be found in a "savings glut" that started in Asia, notably in China. Simply put he says the Chinese accumulated trade surpluses with the rest of the world, principally the U.S., and then preferred to sit on the money, rather than spend it. Deflation is the result.

This is a very curious view, given that the Chinese economy was booming along, year after year, with overall spending hitting near double-digit growth rates. Did Bernanke expect them to spend even more?

What he wanted China to do was practice monetarism, allow its exchange rate to rise, increasing Chinese costs, and reducing its trade surplus. Instead China had a development plan based on manufacturing exports creating the industrial base needed to transform a subsistence economy into one generating cash for investment. Chinese economics was about doing the right thing for China, not adopting monetarism.

In a tribute to Milton Friedman, the father of modern monetarism (David Hume originated the theory) Bernanke said that Friedman had been right in his book with Anna Schwartz the great depression was caused by the collapse of the money supply. He went on to say that because of Friedman we now know what to do, and there would not be another Great Depression.

Bernanke is himself an academic authority on the Great Depression. In his research, he surmised that the failure of the Federal Reserve to inject liquidity into the banking system had caused the depression. As U.S. central banker he has not wanted to repeat the same mistake. This is the thinking that has cost the U.S. $12.8 trillion so far.

There is another view. The U.S. banking crisis was caused by the failure to bring U.S. banking practices under effective international control and regulation. Large financial institutions, both American and non-American, took advantage of the exorbitant privileges accorded the U.S. dollar within the world financial system to make trillions of dollars in loans for the creation of financial derivative products, while central banks looked the other way.

Attaching the power of credit creation -- the ability to produce tomorrow and repay what is borrowed today -- to doubtful ventures such as credit default swaps has undermined the balance sheets of banks around the world, rendering them incapable of meeting future obligations.

The banks are not just short of money. Bad debts abound. No one knows when normal operations will resume.

Putting the major U.S. banks into receivership would have cost much less than $12.8 trillion dollars. Rather than bailing out the owners of the banks, the U.S. authorities should have bought out the shareholders. With bank shares trading at 80 per cent discounts from previous highs, the cost would have been minimal.

In 1936, the great British economist John Maynard Keynes called the monetarist quantity theory of money "curious." He pointed out that money can be hoarded, or used for speculation; it does not have to be spent on investment or for consumption. In bad times, Keynes argued, governments should invest and ensure that people can consume. In this light, lending $12.8 trillion to U.S. bankers, so they either hoard the money, or reopen the financial casinos that led to the problems in the first place, does not seem all that bright.

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