The Dilemma of Economic policy

By Equar D. Negash

June 18 2008

Most economic analyst believes the current economic slow down in United States of America started in the housing market crises. US Economy is the biggest economy in the globe. In one way of another, economic down turn in USA affects the world economy at large. Most economic analyst agreed on the cause of the housing market crises which they call it housing bubble. According to some economic literatures, housing bubble is a term given to economic boom in the real state market. It occurs when housing price jump up unhealthily instead of rising gradually with the rate of inflation. A few years ago, as we all remember, the house prices in USA were increased fast. I remembered in my neighborhood there was an increase of 35% in prices of houses in a year. What pushed price that much high in this particular market? First, the interest rate was by any measurement very low which encourage people to by houses. Second, there was a very lenient lending standard. Lenders, encouraged by the fast growing house prices, gave loan to borrowers without considering credit history and did not take into account the ability to pay down payment. Third, the negative effect of the speculative behavior of some participants of the market was also played a role in this issue.

These all pushed the demand for housing far more than its supply which eventually led to higher price. However, to account for risky borrowers, lenders opted to sub prime rate which is adjustable interest rate to higher risk borrowers and low income folks. After few years of grace period, the adjustable rate became into effect and forced people to pay significantly more monthly mortgage payment. This situation put most if not all sub-prime borrowers in a difficult position to pay their mortgage. Consequently, default rates were increased to its highest level in decades. The number of foreclosures in this market is rising alarmingly and housing prices continue to decline. The spill over effect of these crises affected the US economy in particular and the world in general. The first victims of this crises was the financial market mainly Banks and mortgage agencies. This situation forced the Federal government and Federal Reserve to take actions to control the crises before it causes a big damage. These actions were sometimes administrative measures, like freezing the sub-prime rate for some time to give house owners a relief. In some case, they used the pure economic policy to fight the growing crises. The adjustment of the interest rate by Federal Reserve is the main economic policy to affect some variables of the economy. The decision of the Bush administration to give out incentive checks for millions of Americans was also part of the effort to give the economy a big push. Injection of money into the market by Federal Reserve to bring liquidity back into the market was also another attempt to fight the crises. Are all these economic policies affect only their intended target?

The FED has been cutting interest rate continuously to help the weak economy revive and to stop the country from plunging into recession. The overall motive is to make cost of investment cheap and encourage investors so that to push the economy up. However, in times of weak economy, low interest rate coupled with more liquidity in the market would affect the value of the currency to decline in terms of other major foreign currencies. This situation led into high inflation. That is the dilemma of policy actions. When ever you think a positive result there is always set back to the action. With the fast increasing crude price in international market, the weak dollar contributed a lot to 4 dollars plus per a gallon in USA. Hence, inflation is by any standard high mainly due to food and gas prices. What is the implication to Ethiopian Economy?

Many of us, in Diaspora, are not convinced when we read some reports of the World Bank stating economic growth in Ethiopia. We see a positive economic growth year after year. However, there are other troubling numbers; the unemployment rate and inflation rate have been increased fast. A few years ago 1000Birr for a quintal of Teff was unthinkable. What caused this inflation? According to Prime Minister Melese, the causes are higher economic growth, greedy investors and farmers who demands a higher price for their product. Even though I do not have any idea about the last two factors, I agreed with him in the first one. Economic growth and inflation are a trade off; high economic growth is meant a high inflation. Economic growth push the demand for goods high compared to its supply which eventually leads to high price of goods and services. In this regard the prime minister is right. Nevertheless, it is the responsibility of the government to find the perfect balance between inflation and growth. Just pursing economic growth as an objective is definitely a mistake if inflation is not taken into account. Growth for a couple of years, even for a decade is not really difficult to attain, what is difficult is to sustain the growth so that the people can benefit from it. Inflation is the main enemy of sustainability because it erodes any benefit from growth. Inflation hurts propensity to consume and investors due an expected cost incur to them. Obviously, these damage the economy.

Inflation rate in Ethiopia is not expected to be high like this. I think this happened because of the dilemma of economic policy. There is no economic policy with out negative consequence. However, if you do not prepare to minimize the problems, the consequence is far beyond expected. I do not think the current government’s action, distributing wheat, sugar, salt and the like helps to contain inflation. This may help consumers to get a relief from the soaring price. Long term solution is to purse a right economic policy, that is, there is no need to push for growth without considering other economic variables.