American Central Bank Seen Reinflating Financial Bubble

The Financial District in New York City, New York, November 10, 2011
The Financial District in New York City, New York, November 10, 2011 (Steve Minor)

Fear is rising that the American central bank’s expansionary monetary policy might be inflating another bubble. Having flooded financial markets with some $2 trillion in easy money since the summer of 2007, the Federal Reserve has hampered a necessary reallocation of resources that would have benefited the American economy as a whole in favor of propping up the baking industry.

Late last year, the central bank announced that it would continue to keep interest rates near zero and pump money into the economy as long as it takes for unemployment to come down to 6.5 percent. It stood at 7.6 percent in March, having slowly dropped from a 10 percent high since October 2009.

Yet five years into the Fed’s monetary policy experiment, millions of Americans remain out of work. ProRepublica‘s Jesse Eisinger pointed out in The New York Times last month that in March, “a smaller percentage of working age people were actually working than at any other time since 1979.”

Rather than fuel a sustainable economy recovery, he argued, “the Fed has kindled speculation. Investors are desperate for yield and are paying up for riskier assets. In areas like real estate, structured finance and equities, the markets are ahead of the fundamentals.”

Quartz‘s Simone Foxman similarly reported on Monday that even the central bank itself is starting to worry about asset bubbles. Federal Reserve chairman Ben Bernanke said last week that he was “watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk taking which may affect asset prices and their relationships with fundamentals.”

The problem, according to Foxman, is that it’s “hard to know what ‘excessive risk taking’ would look like these days because the central banks’ involvement in the markets is distorting the usual ways risk is measured.”

Detlev Schlichter, a former investment manager and author of Paper Money Collapse (2011), therefore likened the Fed’s policy last year to a giant placebo. “It is not true medication as it evidently does not address the economy’s fundamental ills but a tool for nationwide mass hypnosis,” he wrote at his blog. It does so by driving down interest rates and cajoling investors into economic activity.

Low interest rates should signal “the availability of a large pool of voluntary savings that desires to be invested and to be translated into productive assets,” Schlichter explained. By printing new money and keeping interest rates near zero, the Federal Reserve hopes to encourage such investment in the absence of savings.

In doing so, it has certainly “sabotaged the redirection of scarce capital from the bubble industries that had benefited from the credit boom toward new, productive and more sustainable employment in other sectors” and might even be setting the stage for another crisis.

Necessary Financial Correction Has Yet to Come

The Financial District in New York City, New York, November 10, 2011
The Financial District in New York City, New York, November 10, 2011 (Steve Minor)

The recent quiet in the eurozone and American politicians’ cavalier teetering on the brink of a “fiscal cliff” seem to suggest that the crisis is over. But the lack of urgency on the part of policymakers mustn’t be mistaken for an actual improvement in the economic prospects of both Europe and the United States.

The crisis that started in the American housing market in late 2007 and became a global financial panic in 2008 isn’t over. Rather the necessary contraction has been extended by government deficit spending and central bank financing. The former has seemingly run its course. The latter may go on for much longer, perhaps even as long as it takes for the economy to rebalance itself. Or it may not. In which case the collapse will be all the greater when it does happen.

The American Federal Reserve certainly seems to think it can go on. In early December, it announced that it would continue to pump money into the economy until unemployment drops below 6 percent. Financial markets were ecstatic. It means cheap money at least until the game is up. But the move is really one of desperation. Every policy option has been exhausted. The only thing left to do is continue to prop up a banking sector that should have partly gone under in 2008 with evermore free money — debasing everyone else’s money in the process.

The Federal Reserve tried this before. Indeed, it’s what brought on the housing bubble in the first place. When the dot-com bubble burst around the turn of the century, the central bank managed to stave off the contraction that was necessary to correct the hype of the late 1990s.

The money it poured into the economy to keep the financial industry afloat found its way into speculative if not outright ludicrous mortgage products. Combined with semi-private mortgage providers Fannie Mae and Freddie Mac that were politically incentivized to loan to low-income households that no truly private bank would have ever considered taking on as clients, it made for a dangerous situation indeed that had to blow up. Read more

American Monetary Policy Doesn’t Stimulate Job Growth

Ben Bernanke attends a meeting of the Board of Governors of the Federal Reserve in Washington DC, August 7
Ben Bernanke attends a meeting of the Board of Governors of the Federal Reserve in Washington DC, August 7 (Talk Radio News/Lingjing Bao)

In what is deemed (another) unprecedented step on the part of the American central bank to stimulate growth, the Federal Reserve announced on Wednesday that it would hold interest rates near zero and pump money into the economy as long as it takes for unemployment to drop to 6.5 percent.

The Federal Reserve is unique among central banks in that it has a mandate to promote full employment. Still, Wednesday’s announcement is something of a shock because the Fed has never so explicitly linked monetary policy to job growth.

There is one condition: the present policy will be maintained as long as inflation doesn’t go over 2.5 percent. It is unlikely to. Despite the Federal Reserve’s very best efforts, there is a deleveraging process going on — both natural and necessary after financial institutions and homeowners assumed far too much debt in the years preceding the crisis.

The Federal Reserve interprets this deleveraging process as a threat to economic growth, which of course it is, and has pumped some $2 trillion into the economy since the summer of 2007 to stem it. As a result, the process has been weakened and the United States are still waiting for a full recovery.

That recovery cannot happen as long as the banks still have massive debts on their balance sheets which they have no reason to write off because the Fed is giving them virtually free money. The banks don’t use it to invest in businesses, as the central bank would like them to, rather use it to shore up their own balance sheets. As a result, there is no extra economic expansion and therefore no new jobs. Read more

Federal Reserve Chief Says Monetary Stimulus Worked

Ben Bernanke attends a meeting of the Board of Governors of the Federal Reserve in Washington DC, August 7
Ben Bernanke attends a meeting of the Board of Governors of the Federal Reserve in Washington DC, August 7 (Talk Radio News/Lingjing Bao)

Since the start of the financial crisis in the summer of 2007, when the subprime mortgage market in the United States collapsed, the Federal Reserve has pumped some $1.9 trillion in the economy in an attempt to revive it.

Most of this money was created during the first round of quantitative easing since November 2008 when the Federal Reserve took over more than $1 trillion of the American banking sector’s mortgage exposure. The second round of quantitative easing saw the Fed purchase some $600 billion worth of United States Treasury bonds in order to reduce the country’s borrowing costs.

For all this printing of money, it can hardly be said that confidence in financial markets is restored. Unemployment — the American central bank is unique in that it has a mandate to promote full employment — hovers at 8 percent which is the same rate as when President Barack Obama took office. There’s no indication that the Federal Reserve’s monetary expansion has worked except for the ominous threat that “things could have been worse.”

Yet in Jackson Hole, Wyoming last Friday, Chairman Ben Bernanke declared his policy a success because “the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields.” He added, “These effects are economically meaningful.”

Indeed! In buying hundreds of billions of dollars worth of Treasury bonds, the central bank has not only expanded the money supply well beyond what was reasonably required to keep pace with lackluster economic expansion; it has aggravated the United States’ debt crisis because the government could continue to borrow cheaply and freely to finance high deficit spending which it probably wouldn’t have been able to do without the Fed’s help. Read more

The “Giant Placebo” That is Monetary Stimulus

Treasury Secretary Timothy Geithner and Federal Reserve chairman Ben Bernanke testify before the House Committee on Oversight and Government Reform in Washington DC, March 21
Treasury Secretary Timothy Geithner and Federal Reserve chairman Ben Bernanke testify before the House Committee on Oversight and Government Reform in Washington DC, March 21 (Oversight and Reform)

Federal Reserve chairman Ben Bernanke gave no indication of planning additional monetary stimulus when he testified before Congress on Thursday. As unemployment in the United States inched up a bit in May, there was an expectation in markets that the central banker would inject more money into the economy. He didn’t but he isn’t backing down on his expansionary money policy either.

Despite two rounds of quantitative easing from the Fed, unemployment still hovers over 8 percent and it can hardly be said that confidence is restored.

The policy has not fundamentally improved economic conditions in the United States either. Indeed, it may have undermined a sense of urgency on the part of lawmakers to do so. That is why Detlev Schlichter, author of Paper Money Collapse (2011), likens it to a giant placebo. “It is not true medication as it evidently does not address the economy’s fundamental ills but a tool for nationwide mass hypnosis.” It does so by driving down interest rates and cajoling investors into economic activity.

“In a free market,” explains Schlichter, “low interest rates usually signal the availability of a large pool of voluntary savings that desires to be invested and to be translated into productive assets.”

But in the absence of a healthy economy that lifts equity markets, and in the absence of savings that can be used for true capital formation, a mirage of health and savings and capital can still be generated with the help of the printing press.

So naturally, by keeping short-term rates below .25 percent for over three years and purchasing some $2.3 trillion in long-term securities under the guise of quantitative easing since the financial panic began in December 2008, the Federal Reserve has managed to create the illusion of a recovery but it has done so by inflating a bubble that can only have set the stage for the next crisis.

Moreover, as Schlichter points out, the repeated capital injections into financial markets have prevented a necessary recalibration of the banking industry and therefore hampered a true recovery. Bad debt is still on the books of major financial institutions and preventing them from investing in businesses. Or, as Schlichter puts it, “the policy sabotaged the redirection of scarce capital from the bubble industries that had benefited from the credit boom toward new, productive and more sustainable employment in other sectors.”

If a large-scale misallocation of resources and substantial mispricing of assets, caused by the credit boom that popped in 2007, are at the heart of the crisis, says Schlichter, “then you may agree with me that monetary accommodation will not only make the economy not better, it actively hinders the healing process. And it does so by providing a temporary placebo that seems to quickly lose its effectiveness.”

Bernanke’s Money Printing Spree Continues

The Federal Reserve last week announced that it expected to keep interest rates near zero well into 2014 in an attempt to stabilize markets and help the American economy recover. It hasn’t so far but Chairman Ben Bernanke seems to believe that there just isn’t enough cheap money in circulation yet.

The central bank has kept short-term rates below .25 percent for over three years and purchased some $2.3 trillion in long-term securities during two rounds of “quantitative easing” since the financial panic began in December 2008.

When the Fed initiated its second round of quantitative easing, effectively printing $600 billion, Chairman Bernanke took to the pages of The Washington Post to explain how the “easier financial conditions” he created would stir economic growth.

Lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

That was twelve months ago. Homeowners are still struggling. Investment has stalled, in part because of the regulatory uncertainty that the Obama Administration has created. Stock prices do move up every time the Fed injects more money into the market but the effects aren’t felt in the real economy because it’s a game of smoke and mirrors and everyone knows it.

You cannot create money out of thin air and expect it to solve a crisis that was made by too much cheap money in the first place.

In his defense, Bernanke admitted that the Federal Reserve cannot save the economy on its own. But it can make prolong the slump by trying to stave off the contraction that must happen if the massive misallocations of credit and investment that were built up in the years preceding the downturn are to be filtered out of the system.

More Cheap Money Won’t Fix Our Economy

On Wednesday, the Bank of England, the Bank of Japan, the European Central Bank and the Federal Reserve announced a plan to boost liquidity in financial markets. Under the plan, private banks will have access to cheap dollars for as long as the global debt crisis rages and they aren’t borrowing from one another. Stock indices responded favorably to the news, but the plan will, at best, only provide short-term relief.

The lack of confidence in financial markets hasn’t dissipated since the Fed printed nearly $2 trillion, so why does anyone expect the latest, actually more modest central bank intervention to have any long-term effect?

Maybe they don’t and they’re just buying time (what an appropriate expression) for politicians to come up with the answer. Given their unwillingness to seriously cut spending and not just restrain the future growth of government, it’s no surprise that investors are increasingly weary of lending these people money. Even Germany, that bastion of frugality, is struggling to sell its bunds at an affordable rate.

It’s not just the Greeks and the Italians who are bankrupt — although their debts are so colossal, one wonders how any financier could have justified loaning them money in recent years. It’s the mixed economy, that contraption of public-private entanglement known as the welfare state, that has run its course. The spectacle of Portuguese mass transit workers striking because their Christmas bonuses were cut in half is ample evidence of the moral bankruptcy of the progressive fantasy that markets could be made to work “better.”

Even in the face of sovereign default, a calamity that is virtually unprecedented in modern times, there are economists, politicians and union leaders who won’t recognize that the game is up, let alone that the average public-sector worker would be told honestly by their representatives what’s at stake. It’s not just their pensions but their livelihoods that depend on the assumption that governments cannot go broke and that central bankers and politicians can stop the contagion if only they push this button or pull that lever, as if the economy were a machine that can be “kickstarted” into growth mode.

We will not have growth in the West unless and until the massive misallocations of credit and investment that have been built up in the last ten years are filtered out of the system. This can only happen if the market is left to its own devices so worthless debt can be written off and firms can fail.

It’s a somber prospect that our leaders are trying desperately to avoid, but all their efforts to contain the damage of the credit crunch have only made things worse. Cheap money got us into this mess and it’s not going to get us out. Now is the time to repent.

This article originally appeared in The Daily Caller, December 3, 2011.