U.S. decapitalization, easy money, and asset price cycles.

• Author: Dowd, Kevin
• Position: Essay

In Matthew 25: 14-30, Jesus recounts the Parable of the Talents, the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence, He then returns and holds them to account. The first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn't be bothered even to put the money in the bank where it could earn interest. Instead, he simply buried the money and gave his master a zero return. He is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth.

In the modern American version of the parable, the eternal truth of the original remains: Good stewardship is as important as it always was and there is still one master the American public (albeit in name only) who entrusts capital to the stewardship of his supposed servants. Instead of three, however, there are now only two: the Federal Reserve and the federal government. They are not especially wicked, but they certainly are incompetent. They run amok and manage to squander so much of their master's capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment. For their part, the two incompetent servants deny all responsibility, as politicians always do, and since there is no accountability (let alone Biblical justice) in the modern version, ride off into the sunset insisting that none of this was their fault.

U.S. Asset Bubbles: Past and Present

The story starts with the Federal Reserve. Since October 1979, under Paul Volcker's chairmanship, the Fed's primary monetary policy goal had been the fight against inflation, a fight he went on to win though at great cost. Given this background, many monetarists were alarmed by Fed Chairman Alan Greenspan's formal abandonment of monetarism in July 1993, but a subsequent tightening of policy in 1994-95 had caused satisfactory amounts of distress on Wall Street and seemed to indicate that the overall thrust of policy had not in fact changed.

The great change in U.S. monetary policy, so far as it can be dated, came early in 1995. In his biannual Humphrey-Hawkins testimony to Congress on February 22-23, Greenspan indicated that his program of rate rises, the last to a 6 percent Fed funds rate on February 1st that year, had ended. Elliptical as ever, Greenspan's hint of easing was veiled: "There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see that underlying forces are acting ultimately to reduce price pressures" (Greenspan 1995: 17). The Dow Jones Index rose above 4,000 the following day, and was off to the races.

By December 5, 1996, the Dow was already at 6,400, and Greenspan famously expressed his doubts about the market's "irrational exuberance." Nonetheless, he did nothing tangible to reinforce his skepticism and pushed interest rates generally downward over the next three years. In July 1997, he then came up with an explanation of why the high stock market might not be so excessive after all. In his usual Delphic manner, he remarked that "important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy" (Greenspan 1997: 2). The press seized on these utterances as confirming a "productivity miracle" that turned out later (like its predecessors the Philips curve and the Loch Ness monster) to be a myth, but not before it gave a nice boost to tech stocks in particular, which positively boomed. Only in 1999 did Greenspan begin to take action, pushing Fed funds rate upward to an eventual peak of 6.5 percent in 2000, by which time tech stock prices had reached stratospheric levels and then soon crashed.

The cycle then repeated. In January 2001, Greenspan began a series of interest rate cuts that saw the Fed funds rate fall to 1 percent in 2003, its lowest since 1961. He held it at that rate for a year and short-term interest rates were to remain below inflation for almost four years. This was a much more aggressive monetary policy, and the results were entirely predictable. In Steve Hanke's (2008) memorable phrase, there was "the mother of all liquidity cycles and yet another massive demand boom," the most notable feature of which was the real estate boom. The rest is history. (1)

Greenspan's successor Ben Bernanke then continued his predecessor's loose monetary policy with missionary zeal. He brought the Fed funds rate, which the Fed had belatedly pulled up to 5.25 percent in 2006 and held there for a year, back down to 2 percent by the onset of the crisis in September 2008. By then the rate of growth of MZM, the best currently available proxy for broad money, had been running into double digits for some time. Over the next six months MZM increased at an annual rate of 20.4 percent, while the monetary base doubled. Over this same period, the Fed funds rate was brought down from 2 percent to a mere 25 basis points, at which level it has remained ever since, and these easy money policies were supplemented with nearly $2 trillion in quantitative easing (QE). After March 2009, the monetary aggregates then remained fiat for a year, but in April 2010 MZM started to rise again (at an annualized rate of 6.8 percent in the six months to October 2010) and, as we write, the Fed is embarking on QE2--with yet another $600 billion in quantitative easing due to hit the system.

If past expansionary monetary policies led to bubbles, then we should expect the even more expansionary policies pursued since the onset of the crisis to produce new bubbles, and this is exactly what we find. Within the United States, there are at least three very obvious bubbles currently in full swing, each fuelled by the flood of cheap money: Treasuries, financials, and junk bonds. (2) The Treasury bond market has seen a massive boom since 2007, fuelled by a combination of large government deficits, enormous investor demand, and low interest rates pushing prices up to record levels.

The current "recovery" in financial stocks is almost entirely an artificial bubble. The Fed's interest rate policy allows banks to borrow short-term at close to zero and invest at 3 percent or so in long-term Treasuries and about 4.5 percent in mortgage bonds, which are now openly guaranteed by the federal government. This enables banks to sit back with their spreads of at least 3 percent, leveraged 20 times to give a comfortable gross return of more than 60 percent. Becoming a yield curve player is far more profitable and avoids all the tiresome effort and risk of lending to small business. It is therefore no wonder that lending to small and medium enterprises--on which economic recovery really--depends remains, at best, anemic. The result is a bizarre situation in which the banks appear to recover while their supposed core activity-lending--remains stuck. The reality, of course, is that lending is no longer their core business.

The banks' true weakness is confirmed by other factors. Current accounting rules, so-called lair value accounting rules, artificially inflate banks"...