It’s Déjà Vu All Over Again

This past week, Chairman Bernanke indicated his belief that there are no “obvious” asset bubbles in our economy right now.  To quote Bankruptcy Ben, “It's extraordinarily difficult to tell, but it's not obvious to me … there are any large misalignments currently in the U.S. financial system.”  

What is he thinking?  The stock market is currently a huge bubble.  From October 2007 to March 2009, the Dow Jones Average fell by about 50 percent.  This is indicative of the fact that the previous market highs were out of whack for market conditions and needed to come down to reality.  That is how the free market works when it is given the opportunity.  Since last March, in just nine months, the Dow has rebounded off its low by an astounding fifty-three percent!  It's a bubble being fueled by all the cheap dollars the Fed is injecting into the economy.  

If you don't believe me, Mary Miller, director of fixed income for the T. Rowe Price Group indicated at the company's symposium in Baltimore on Thursday, “I'm familiar with one institution that just borrowed $400 million – because they could – and then called up and said, 'What should we do with it?”  That is what a lot of banks are doing with our money that has been given to them – not lending it but speculating once again in another Fed induced bubble.  It is outrageous.

What is even more outrageous is Bernanke saying essentially that the current stock market fueled by his printing press is not a bubble.  The economy is still in the dumper – I won't bore or depress you further with all the numbers, but the stock market continues to climb to exorbitant highs.  Give me a break and come clean Mr. Chairman.

Bernanke is clearly being disingenuous because if he acknowledged the truth it would indict the system that he has made a very good living from.  The Federal Open Market Committee must be agonizing over whether to leave interest rates at essentially zero and continue to perpetuate the stock market bubble or raise rates and watch that bubble burst.  It is going to happen sooner or later – sooner would still be painful but less extreme.  Bernanke may not know it but the no win quandary he faces explains to a degree the Austrian School of Economics' Business Cycle Theory.

Under the theory, business cycles, circular boom and bust periods, are not considered a natural phenomenon of free markets.  Instead, government interference in the economy, specifically through manipulating the money supply, is the culprit.  Booms are caused by artificially low interest rates and busts occur when the Fed decides to provide an “easy landing” for an overheated economy by raising rates.  In both cases, low rates and higher rates, fallible humans at the Fed decide the rate levels.  Thus, the market plays little if any part in the determination.  Having been taught in an American public school, I was cynical myself of this analysis.  After all, my Franklin Roosevelt loving social studies teachers taught me that capitalism has certain failures which we need the government to correct for us.  

However, by looking at historical data it is possible to see the correlation between low rates (the cause of booms) and higher rates (the pin that punctures the bubble) and booms and busts.  Because I have a day job, I only had time to analyze rates and recessions since 1971.  1971 is significant because that is the year Nixon opened the flood gates for the Fed's printing presses by abolishing the last vestiges of the Gold Standard.  The following is the year of recession followed by the lowest rate during the preceding period, the highest rate during the preceding period, and the spread between low and high rates:

November '73 – 5% – 11% – 6 points
January '80 – 4.75% – 15.5% – 10.75 points
July '81 – 15.5% – 20% – 4.5 points
July '90 – 5.875% – 9.75% – 3.875 points
March '01 – 3% – 6.5% – 3.5 points
December '07- 1% – 5.25 – 4.25 points

Source:  www.chartoftheday.com
              http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

The most important observation that can be made from examining the data is there was a significant spread between the lowest rate and the highest rate before each recession.  These wide disparities in rates sent the wrong signals to investors and entrepreneurs.  In other words, because money and credit were in abundance during artificially low rate intervals entrepreneurs invested in ways that market forces would have prevented if the supply of money was realistic (market determined).  Thus, a misallocation of resources took place.  Too many products were produced; too many houses were built; too much money was invested in companies with little or no earnings.  All this happened because money was cheap and plentiful.  Remember folks borrowed millions and invested in dot com companies before many of them even went online.  Also, remember that right now we still have a glut of homes because Alan Greenspan kept rates near one percent for close to three years!  Of course it was the housing crisis that led to this current recession.

When the Fed pulls the rug out from under the artificially propped up economy by raising rates significantly, thereby increasing the cost of money, people stop borrowing and many lose their jobs because products and services are no longer being bought with borrowed money.  With higher interest rates, adjustable rate mortgages rise and homebuyers default on their debts.  Asset prices fall and unemployment rises due to further cutbacks in consumer spending.  The bubble is burst and recession sets in.

Now, recessions are unfortunate, but necessary like vomiting is essential during the flu – to rid the organism of bad material.  In the case of the economy, the bad material is all the mal-investments that were made during the boom.  

Of course, our economy was not given the chance to vomit the mal-investments made during the last boom.  Through so-called “stimulus” and the easy money policies of Bernanke's Fed we are into our 24th month of recession.  What's more the reckless monetary policies of the Fed have blown up another bubble in the stock market.  

Which brings us back to the beginning of our article – Bernanke must be joking; there is a huge bubble in the stock market because there is no good reason for the extraordinary rise in stock prices given that consumers aren't spending; commercial real estate is about to hit a crisis; and unemployment is still rising.  The only explanation is a bubble caused by artificially low interest rates.  In the words of Yogi Berra, “It's déjà vu all over again.”  The bright side is perhaps Bernanke can find work as a stand-up comic after his tenure at the Fed is over.  He does get a good one off every now and then.           

Kenn Jacobine teaches internationally and maintains a summer residence in Haywood County, North Carolina.  For a podcast of this post go to:  The View from Abroad.


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