Bernanke's Bubbles

The time cost of money:

Interest rates play a vital role in market economics. Among many other things, they reveal the time cost of money throughout the economic decision making process, and impose an important degree of discipline on borrowers and lenders alike.
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For about a century, now, the U.S. - and the world - have repeatedly paid an enormous price for Federal Reserve efforts to substitute administered alternatives for market interest rates.

Yet Keynesians and monetarists think nothing of disabling the market's interest rate function. For about a century, now, the U.S. - and the world - have repeatedly paid an enormous price for Federal Reserve efforts to substitute administered alternatives based on all too fallible human judgment for market interest rates. See, Blatt, "Understanding the Great Depression & the Modern Business Cycle," Part II, "Government Monetary Policy." (Table of Contents and Introduction) See, also, eight articles on Meltzer, "The History of the Federal Reserve," beginning with Part I: "The Search for Monetary Stability (1913-1923); and Friedman & Schwartz, "Monetary History of the U.S., Part II: Roaring Twenties Boom - Great Depression Bust (1921-1933, and Part III: "The Age of Chronic Inflation (1933-1960).
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By the fourth year of a low interest rate policy, the bubbles are growing exuberantly and the houses of financial cards will include great cathedrals whose collapse may threaten the entire economy.

The bubble mania that preceded the recent Credit Crunch recession afflicted real estate, securities and banking - the most heavily regulated industries in the nation.

The entire economy must eventually become increasingly distorted in the absence of market interest rates.

Pushing interest rates down may be alright for a few months or even for a year during some crisis period, but when interest rates are held down substantially below market rates for two or three years, the economy naturally adapts to that low interest rate environment. All manner of economic bubbles begin to expand and those prone to take great risks with borrowed money are greatly encouraged. By the fourth year of a low interest rate policy, the bubbles are growing exuberantly and the houses of financial cards will include great cathedrals whose collapse may threaten the entire economy.
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Market disciplinary mechanisms are never perfect so regulation to supplement them can be useful. However, regulation is at best a weak reed that can never substitute for market disciplinary mechanisms. Regulation is always expensive and always poses a threat to market efficiency.
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The bubble mania that preceded the recent Credit Crunch recession afflicted real estate, securities and banking - the most heavily regulated industries in the nation. The bubble mania was caused at the most fundamental level by a series of government policies that disabled market disciplinary mechanisms and the obvious inadequacy of regulatory mechanisms in the absence of those market disciplinary mechanisms. See, "Understanding the Credit Crunch." Besides artificially low interest rates, these misguided policies included, among others, the moral hazard of widespread explicit and implicit credit market guarantees, the allocation of resources into politically favored markets like housing and agriculture, noxious tax code incentives such as those that encourage debt financing and punish equity financing, and the distorted incentives of even low levels of chronic inflation and dollar devaluation.
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Interest rates perform many essential roles, one of which is to impose the time cost of money on financial decisions. Thus the entire economy must eventually become increasingly distorted in the absence of market interest rates. When the Federal Reserve is ultimately forced to allow interest rates to rise towards market levels - as eventually it must - vast strains will test the economy. All manner of bubbles will burst and some of those houses of financial cards will crumble - and everybody will blame the markets and seek scapegoats for yet another disastrous failure of Federal Reserve monetary policy.
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Where is the price inflation?

These failures generally take about four or five years to develop in an economy as strong and complex as that of the United States.
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With unemployment running at almost 20% after six years of strenuous New Deal industrial policy, monetary inflation and budget deficit financing, the FDR administration was a proven failure.

Keynesians and monetarists are harshly critical of the Federal Reserve policy during 1936 and 1937, but they almost never acknowledge the 8.3% surge in price inflation as measured by the GNP deflator, or explain how such a thing could have happened while unemployment still exceeded 14%.

Let's look at the record.

New Deal monetary inflation and low interest rate policy initiated in 1933 resulted in price inflation as measured by the GNP deflator surging as high as an 8.3% annual rate during the first six months of 1937. As bad as the Great Depression undeniably was, it would have become much worse as an inflationary depression. Even during the Great Depression, most of the workforce had jobs, and many of those workers were doing quite well as prices frequently declined faster than wages. However, inflation affects everybody except those few agile speculators capable of taking advantage of it.

While the Federal Reserve kept its discount and acceptance rates low during 1936 and 1937, it responded to surging price inflation by doubling bank reserve requirements to drain credit from the economy. The FDR administration was also suitably frightened by the surge in price inflation and actively supported this monetary policy shift. Private interest rates were pushed sharply higher. The economy crumbled and unemployment soared.
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With unemployment running at almost 20% after six years of strenuous New Deal industrial policy, monetary inflation and budget deficit financing, the FDR administration was a proven failure. However, this was quickly forgotten with the advent of WW-II and the popular myth that the New Deal "saved capitalism." Keynesians and monetarists are harshly critical of the Federal Reserve policy during 1936 and 1937, but they almost never acknowledge the 8.3% surge in price inflation as measured by the GNP deflator, or explain how such a thing could have happened while unemployment still exceeded 14%.

Price inflation pushed higher in 2005 and 2006, and the Federal Reserve was thus forced to raise its discount rate to more than 6% and to allow the federal funds rate to rise to over 5% by the middle of 2007.

The Kennedy/Johnson administration inherited a strong financial position from the Eisenhower administration but was intent on employing Keynesian policies to increase economic growth. The Kennedy tax cuts were supported by a Federal Reserve policy of rapid monetary expansion to hold interest rates down. By 1966, price inflation was pushing higher and by 1968 the dollar was in a state of collapse as the economy was pushed into the Keynesian inflationary morass of the 1970s.
The Carter administration and the Federal Reserve took just four years to push price inflation into double digit territory. It took a monetary austerity policy and the severe 1980-1982 recession imposed by the Volcker Federal Reserve to begin the long process of unwinding the price inflation process. Price inflation still averaged over 4% between 1982 and 1990 and was a significant restraint on economic growth.
The Bush (II) administration and the Federal Reserve financed massive deficits and kept interest rates substantially below market interest rates as economic bubbles grew exuberantly and financial houses of cards became great cathedrals of debt. They also actually reduced regulatory safeguards while continuing a trend in government policy of disabling a wide variety of market disciplinary mechanisms. Price inflation pushed higher in 2005 and 2006, and the Federal Reserve was thus forced to raise its discount rate to more than 6% and to allow the federal funds rate to rise to over 5% by the middle of 2007.

Strains quickly increased within the world's overextended financial structure as interest rates rose, and the rest, as they say, was history. The markets had been politically stripped of their most important disciplinary mechanisms, but nevertheless the markets were made the scapegoats for the financial collapse. Heavens forefend that the politicians in Congress and the administration should take the blame.
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Of course, the government now uses a different price inflation index than it used in the 1970s. There is widespread belief that if calculated by the 1970s index, the price inflation figures for the 2005-2007 period would have been considerably higher than the official figures, but the extent of the difference has not been convincingly determined. However, while the government can change the publicized price inflation figure, it can't hide the price inflation in the commodities markets or change the public pain or economic damage.
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Creating the next credit crunch:

Today, all the policies that caused the Credit Crunch recession have been made worse. Monetary inflation is rampant and basic interest rates have been kept near zero now into the third year. Explicit and implicit credit guarantees for too-big-to-fail financial, economic and political entities have been further extended spreading moral hazard widely. Creditors seek the highest interest rate returns totally unconcerned by the threat of default. Thus, creditors are transformed from credit market vigilantes to credit market enablers.
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The government responds by strengthening regulatory efforts that impose increasing costs on the economy in the inherently futile effort to make up for this destruction of market disciplines.

The government continues to undermine the supply and demand disciplines of the markets by pushing vast subsidies into favored economic sectors like housing, agriculture and green energy. Fannie Mae and Freddie Mac are kept alive on a financial life support system that absorbs tens of billions of dollars every quarter. The tax statute, among many other noxious incentives, still strongly favors debt capital and punishes equity capital. Chronic price inflation continues to distort economic incentives. Vast entitlements expand without cost controls.
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The government responds by strengthening regulatory efforts that impose increasing costs on the economy in the inherently futile effort to make up for this destruction of market disciplines. Meanwhile, vast increases in sovereign debt undermine the financial strength and stability of the U.S. and many other democratic governments.
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Bubble trouble:

However, the widespread recognition of the increased risks of this monetary inflation period is having a laudable restraining influence. Major financial and economic institutions and even some political entities have built massive reserves against the uncertain future.
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Now, while even long term rates are low, is the time for prudent management to take care of financing needs for the long term.

Already, the Federal Reserve's mortgage holdings - well in excess of a trillion dollars - are not marketable at par.

So, where are the economic bubbles this time? Actually, they are already not hard to find.

Standard inflation hedges are inherently bubbly during inflationary times, and they have indeed already expanded remarkably. They inherently overshoot during inflationary periods and suffer sharp declines when interest rates rise back towards market levels, as inevitably they must. During these next two years, leading up to the 2012 election, Obama and Bernanke will move heaven and earth to put off the evil day. If they succeed, that will just make matters much worse as inflationary pressures increase and hedge prices move even higher.
Commodity price inflation has been running at multiple double digit rates for well over two years already. Not just inflation hedges like gold and other precious metals and oil, but industrial and agricultural commodities as well are being set up for dramatic falls. The constraints on oil supplies that FUTURECASTS highlighted at the beginning of the last decade when prices were well below $20 per barrel have been overcome. There will be no "peak oil" in 2012 or in the succeeding decade. However, oil still moves like an especially volatile industrial commodity and oil production is still subject to major political disruptions - especially in a low interest rate environment where oil in the ground is worth more than oil produced.
Many developing nations that are dependent on natural resource exports are already dependent on bubble economic systems. Russia has seen this play before in the 1980s and is wisely accumulating vast reserves against the inevitable collapse, but Iran and Venezuela among many others are mindlessly spending their money faster than it is coming in and have wrecked the rest of their economic systems. Even wealthy nations like Canada and Australia are likely to be hard hit when the air comes out of the commodity price bubble.
Agricultural land has also been rapidly appreciating as the price of agricultural commodities soar. Although agricultural subsidies will take up some of the slack, these land prices will still decline substantially when agricultural prices decline.
But green energy subsidies do not have as much political support as agricultural subsidies. Congress has to make substantial budget cuts and green energy subsidies are a very vulnerable target. The end or substantial reduction of green energy subsidies will undermine much of the green energy industry.
Financial plans based on the turning over of short term debt will again be faced with collapse. Businesses and financial institutions caught short are always placed under considerable strain when interest rates rise. Many will not survive or will require taxpayer bailouts. Now, while even long term rates are low, is the time for prudent management to take care of financing needs for the long term.
Purchases of big ticket items like ships, airplanes and major industrial units have been pushed forward to take advantage of low interest rate financing. The manufacturers of such items are thus rendered even more vulnerable to the business cycle than they inherently are.
The bond market has also looked bubbly during this period of artificially low interest rates. However, market rates for bonds have already begun to rise in response to the efforts of the Federal Reserve to keep them down. This has let some of the air out of the bond market bubble. The bond market is the first of the bubbles to begin deflating and thus its loss of values during these next few years may be less spectacular than otherwise.
Profligate states like Illinois, California and New York are already hanging on by their fingernails with the aid of federal bailout funds, but those funds may not be renewed this year. The current recovery will provide some relief as tax revenues increase, but that will disappear during the next recession sometime within the next three or four years. Such states provide an abject lesson of the ultimate consequences of liberal economic governance.
The Federal Reserve itself is now exposed to a financial bubble. Its vast artificially low yield mortgage holdings and long term debt holdings lose value as interest rates rise. Already, its mortgage holdings - well in excess of a trillion dollars - are not marketable at par. To unwind these positions, the Fed will have to acknowledge tens of billions of dollars in losses. Will it mark these holdings to market? Don't hold your breath! It will probably hold them until they naturally close out while refusing to acknowledge any losses.
Fannie Mae and Freddie Mac are, of course, in even worse shape with respect to holdings of artificially low yield mortgages. Yet, now as government controlled enterprises, they mindlessly keep accumulating them.

Even bubbles that are rational responses to government policies must deflate sharply when those political influences diminish or end or fail to overcome the next general economic contraction.

These bubbles are still mostly rational responses to the gravely distorted signals in the markets generated by the government policies that have disabled market disciplinary mechanisms. This is clearly still not equivalent to the bubble mania before the Credit Crunch recession.
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However, as this period extends into a fourth and perhaps even a fifth year, it would not be surprising if some irrational exuberance began to be discernable. Even bubbles that are rational responses to government policies must deflate sharply when those political influences diminish or end or fail to overcome the next general economic contraction.
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It is likely that Obama will get through the 2012 election before anything untoward occurs, and that, of course, is the most important objective of Bernanke's monetary policy.

The existence of these bubbles will make 2013 a very interesting year and renders all economic projections beyond 2014 meaningless. Entitlement projections - especially for health care - are blatantly works of fiction.
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The increasing weakness in the dollar increases the nation's vulnerability to economic and financial shocks from abroad that may accelerate these developments. Changes in government economic policy as a result of the recent election could materially affect the timing of these developments but are unlikely to be of sufficient magnitude to materially alter these expectations. Although far from certain, it is likely that Obama will get through the 2012 election before anything untoward occurs, and that, of course, is the most important objective of Bernanke's monetary policy.
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