Fed unleashes greatest bubble of all

December 17, 2008

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.

Now the Fed’s decision to cut interest rates to between zero and 0.25 percent, coupled with a promise to keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in U.S. government debt.

THE ASYMMETRIC EXPERIMENT

Bubble mania is no accident. It is the direct consequence of the Fed’s asymmetric response to shifts in asset prices. Pressed to “lean against the wind” and adopt counter-cyclical interest rate and credit policies in the asset market, senior Fed policymakers have repeatedly demurred.

Led by Bernanke and Greenspan, officials have argued it is too hard and subjective to identify bubbles until afterwards, and not the Fed’s job to second-guess asset allocation decisions of professional investors.

Even if bubbles could be identified, they argue, pricking them would require swingeing rate rises that would inflict widespread damage on the rest of the economy.

Far less damaging to allow asset markets to follow their natural cycle and stand by to cut interest rates sharply, supply liquidity and contain the fallout when the bubble bursts.

But the Fed’s asymmetric policy response to rising and falling asset prices (colloquially known as the “Greenspan/Bernanke put”) directly led to much of the excessive risk-taking which has humbled the financial system over the last eighteen months.

More importantly, the Fed’s decision to respond to the collapse of the technology and stock market bubble by lowering rates to 1 percent and holding them there for an extended period is now widely accepted as a mistake that contributed to the bond bubble and subsequent housing market boom in the middle of the decade.

If the low-rate strategy was a mistake, it was a conscious one. In testimony to the UK Parliament last year, former Bank of England Governor Eddie George admitted the bank had deliberately sought to stimulate the housing market and house prices to support consumption during the downturn.

Greenspan, Bernanke and Co seem to have adopted a similar approach in the United States.
The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.

When the Fed did eventually start to raise short-term interest rates in 2004, long rates remained stubbornly low for a year, and then rose much more slowly than anticipated, a development the puzzled Fed chairman and his able assistant Dr Bernanke described as “the Great Conundrum”.

Even as rates eventually rose, the alchemy of securitization ensured the real cost of credit remained far too low until the subprime bubble finally burst in late 2007.

The second mistake is a basic design flaw in the Fed’s “risk-management” approach to setting monetary policy. Risk management is a nice idea, but not terribly useful. As engineer will explain, risk management involves trade offs and is not cost-free.

The Fed has struggled to formulate a response to “low probability, high impact” events such as the threat of deflation in the early 2000s. Its response has been to cut rates aggressively to ward off the danger of extreme downside events, a strategy officials liken to taking out an insurance policy.

That’s fine, but when these low risk events have not in fact occurred, as was never statistically likely, the resulting policy settings have proved far too loose, and the central bank much too slow to change it.

Concentrating on theoretical but small risks such as deflation has too often blinded the Fed to much larger risks near at hand of bubbles and asset inflation.

INTO THE UNKNOWN

Even as officials recognize policy has played a role stimulating an endless series of bubbles, the Fed finds itself trapped with no way out. Following the collapse of much of the modern banking system, the risk of pernicious deflation is now very real–more so than in the early 2000s.

So like the sorcerer’s apprentice, the Fed has cranked up the Great Bubble Machine for what policymakers hope will be one final time.

The Fed’s “unconventional” monetary strategy comes in four parts:

(1) Cutting interest rates to near-zero to lower the cost of borrowing.

(2) Injecting short-term liquidity into the financial system in the form of bank reserves (quantitative easing).

(3) Trying to pull down yields on longer-dated Treasury bonds through a combination of the jawbone (promising to keep short rates low for an extended period) and the threat to intervene in the market directly by buying longer-dated paper.

(4) Trying to reduce credit spreads above the Treasury yield for other borrowers, and increase the quantity of credit available, by buying mortgage-backed agency bonds for its own account, and financing other market participants to buy securities backed by other consumer credits, auto loans and student loans.

Most attention has focused on the zero-rate policy and quantitative easing at the short end of the curve. But the real significance lies in the unconventional operations targeting Treasury yields and eventually credit spreads at the long end.

Operations at the short end are designed to bolster the banking system and restart lending. But the Fed knows the banking system is not large enough to replace the much more important sources of credit from securities markets.

Operations at the long end are designed to get bond finance and securitized credit flowing. Short-end interest rates and quantitative operations are significant because they help shape the whole term structure of interest rates embedded in the curve.

ONE LAST SUPER-BUBBLE

The strategy has already succeeded in halving yields from over 4 percent in mid October to just 2.25 percent now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a “time-inconsistent” promise to hold interest rates at ultra low levels for an extended period.

The problem is that if the unconventional monetary policy works, and the economy picks up, the Fed will come under pressure to “normalize” rates and reduce excess liquidity to prevent a rise in inflation. The resulting rate rises will inflict massive losses on anyone who bought bonds at today 2.25 percent rate.

Bizarrely, Bernanke and Co are in fact inviting investors to bet the policy will fail, the economy will remain mired in slump for a long period, deflation will occur and interest rates will remain on the floor, as Japan’s have done since the 1990s.

Buyers of real estate and subprime securities have recently been lampooned for foolishly overpaying at the top of the market. Bernanke and Co are gambling memories will prove short and investors will prove just as eager to pay top prices for long-term government and private debt even though the downside is large.

Let us have one last bubble, and when it collapses, we promise not to do any more in future…honest.

For previous columns by John Kemp, click here.

71 comments

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Why does it seem like those in Gov giving out trillions are grads of the “Modoff School of Investment and Lending LLC”. News flash these folks more related to some clown behind the drapes at end of yellow brick road then some soccer helper.. as least the latter had some supervision that could save and repair the mess. . all USA has is China.

Posted by chuck | Report as abusive

The author has presented a well thought out and researched piece here, but fails to account for the human element of the treasury bubble. Astute investors and advisors realize that they are grossly overpaying for safety in the treasury market, but at present there is absolutely no tolerance for risk. Investors are longer willing to watch the net worth fluctuate by 3-5-10% per monthin equity markets. Even when the economy and volatility stabilizes, many investors will likely remain hestiant for quite some time to re-enter risky markets beyond treasuries. Look for munis to move first as things improve, followed by corporates, MBS, preferred and so forth along the risk spectrum.

Posted by Fabian Bartlett | Report as abusive

Basic problem–Keynes. His economic theories, still being used not only by USA but essentially by all major countries, were created in mid 1930′s and used by FDR. Read them and see how irrelevant they are for our world. We now are a global world Keynes could not imagine–airplane, television, internet, cell-phone, etc. Virtually nothing is made in just one country. So one-government solutions will not work. Where is our Adam Smith, Karl Marx, Keynes?

Posted by Richard Gustafson | Report as abusive

B”H

Excellent explanation of the Fed’s efforts to manipulate the market. It happens again and again. Whoever buys long term bonds now will feel severe pain when the dollar collapses and foreigners stop funding our problems. The most recent bubble burst hard in Miami – see http://davidportnoy.blogspot.com for more details on the burning ruins here.

david

Alas, I believe your diagnosis is correct. With luck your prognosis need not be. The Fed and Comptroller of the Currency clearly do not have sufficient tools to deal with various asset bubbles, but that doesn’t mean the situation is permanent. To deal with equity bubbles, margins can be raised or lowered. Surely more can be done to prick or deflate slowly other asset bubbles. The first thing to do however is to demonstrate the willingness to do so, which neither Greenspan or Bernanke were willing to do.

Posted by Eric20008 | Report as abusive

How right you are. Also, the two biggest economic factors that none of the hot-shots in Washington seem to understand are:

1. As people age, their propensity to move to a different house (either new or used) decreases greatly. As 77 million baby boomers reach their sixties, they will not be buying a house (almost no matter what the price). So don’t hold your breath for a housing rebound.

2. The other issue is also demographic. We need SKILLED workers in the 25 to 40 year old age group. They are needed to replace the retiring boomers and pay for the entitlement programs. Immigration is the answer and the logical places to have these souls are India and China.

These fundamental issues must be addressed if we are to avoid the second great depression.

Posted by Jim in San Antonio | Report as abusive

A well thought out article, but without a discussion of the root cause of instability. The author describes the Fed\’s role in a negative feedback control loop, but where the control is applied with too great a delay. This is common in the real world and leads directly to time-delay negative feedback oscillation (think of a beginning bicycle rider who wobbles back and forth barely staying up and compare it to the small, timely and effective corrections of an experienced rider).

But isn\’t there an underlying monetary cause of this instability? Aren\’t the cycles getting shorter and more extreme? Without an underlying instability, even somewhat delayed responses can be timely enough to keep things smooth. Think of the difficulty in control that even an experienced bicycle rider would have with a 16lb bowling ball loose in a basket on the handlebars ;-).

Posted by DaveF | Report as abusive

This insightful analysis gets to the heart of the reality that noboby out there knows how to solve the problems visited on us by bankers who do not understand their own industry. It is is an ongoing case some “trial” but mostly “error”. I will wager that there is already a legion of smart-arse financial gurus thinking of ways to turn these “rescue attempts” to their advantage through the medium of unregulated derivative instruments. This will take us back to square one in about 10 years time.

Posted by anton kleinschmidt | Report as abusive

If we were not concerned about possible negative effects from economic policy decisions that are being made, it is really interesting to think about just what is going on.

For now all of this stimulus is keeping market panic at bay. We were headed for total disaster just prior to the rapid decisions being made to bailout the financial industry, lower rates, commit trillions to social spending and the auto industry. We will pay for all of these decisions down the line and we’ll be able to look back and learn lessons for the next great financial fiasco perhaps another 80 or 100 years from now.

The biggest problem with the Fed’s policies is that they are driven by a man who has absolutely zero understanding of basic economics: Ben Bernanke. How he could not have seen the housing and credit bubble coming is just beyond me. There was no shortage of people (eve though they were in the minority) clamoring for years that this thing was going to burst. That the nation’s top economist completely missed it is evidence of the fact that he is, quite simply, a fool.

And now we are left to deal with the fool’s even greater folly: his idiotic misconception that he can somehow control something as complex as an economy. And even though he has been wrong, every single time over the past several years, he’s still at it. Why doesn’t someone put this man on a boat and let him float out in the ocean where he can do no more damage.

You can give money away for free – hell, you can pay people to take it – and they will not lend if they are afraid or uncertain of getting it back. Period. Why are banks going to lend when they know that other banks have just as much toxic sludge buried in Level III as they do? Why will they lend to businesses that have seen huge drops in orders and may be bankrupt themselves. Why will businesses borrow if they don’t know they’ll have the money to pay it back? Why will anyone lend to consumers who are already underwater? Why will a person who’s already in debt and afraid of losing their job want to borrow money to buy a house or a car?

The short answer is that they won’t. But since he’s an academic, Bernanke doesn’t understand that the real world doesn’t operate according to his ridiculous theories and formulas. Instead, it works pretty simply. People will borrow and spend when they’re confident in the future and they’ll save and retrench when they’re fearful of it. Of course, in academia, they don’t talk about things as silly as “people”.

Instead, Bernanke has seen fit to throw the entire kitchen sink at this thing, even though each one of his previous attempts have failed. He is a classic fool – and a dangerous one, because he’s playing with our money.

!”Not seeing the bubble coming..” is hawgwash!
Anybody who has lived through the seventies and bought decent houses for about twenty thousand or so would and probably is absolutely horrified to see similar houses, starter houses for the young beginning householders, being actively marketed for a half of a million dollars with actually some kind of expectation of really GETTING a half a million for a twenty thousand dollar house. The Chinese had a ssying years ago about organized crime….”I do not know! Bad things happen to those that know!”. The newspaper professionals HAD to know what was happening, but were silenced in order to keep their jobs in organizions that were controlled by interlocking interests of other organizations that were criminally defrauding the people….the banks and their owned or controlled real estate companies…the corrupt politicians ever seeking re-election campaign funds whose complicity was necessary for the vast criminal enterprise to succeed. You can bet that the latest fifty billion dollar Ponzi scheme will have many players running for cover. Maybe the crime just got too big to cover up after all. Kinda like a madam controlling a stable of beauties servicing prominent politicians, and she gets arrested and somehow her ‘black book’ gets ‘taken for evidence’ and then ‘mysteriousely disappears from the evidence room’. Only to resurface in the hands of a tabloid publisher who puts out all the lurid details all over the place and does it every week. Of course some of the times that happens, the political establishment strikes back….they never did find the folks that spread that disease against a tabloid, against Sen Daschle who was probably on to them.. But wait, Sen Daschle now has a new job in a new administration probably not controlled by the monsters of the last eight years. Maybe he KNOWS who was behind it and will catch them.

Posted by Deep Throat | Report as abusive

“the Fed will come under pressure to ‘normalize’ rates and reduce excess liquidity to prevent a rise in inflation”

The Fed need not increase rates and could hold onto the longer-dated debt it picks up through its direct intervention in the debt markets. The results however, will be somewhat similar. Instead of bond prices falling as interest rates are increased, inflation will simply wipe out the purchasing power of bond-holders. So who is “buying” what the Fed is “selling”?

It apears that the federal reserve has technically ordered up the foreign sale of US Treasuries. IMHO
http://www.genusi.com/main.aspx

I refer to my original post.
Why does it seem like those in Gov giving out trillions are grads of the “Modoff School of Investment and Lending LLC”. News

The only difference now is the “New investors” for the money going out is the future generations of USA. This think is so out of control I suspect the truths have long ago been the “First victim” As one poster said,it is impossible for any, even average financial knowledge to NOT KNOW the mortgage, housing, auto, credit card was going to blow up.. And worse yet, a big a bomb is now ticking for 2009-10.. which none address as if that one does not exist…NOR where the bailout funds for it will come from.
We desperately need real knowledgeable folks running this mess with some practical knowledge and even an awareness that without real jobs at real wages with real health care and really fair trade.. and honest tax set ups, NOTHING is going to work. Worse yet “Congress is watching”… and it seems lobbyists are paying.. so it just maybe,
RIP USA we once knew.. only hope may be some true capitalists take over, or as said in Coo-Coo Nest, “the inmates have taken over”.. and perhaps in USA REAL Capitalists of the money, profits reinvested growth, profits cycles really need to do such?
Time to get rid of the guys behind the drapes as it seems the wizards are not, nor are they the alchemists they think they really are, when trying to create dollars from toxic paper..

Posted by chuck | Report as abusive

“The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.”

This says it all!

Posted by Gary S. Hart | Report as abusive

I subscribe to the expressed need to revise the current economic dogma. I’m rather tired of central banks trying to solve a liquidity crisis by making money worthless. Worthless in my pocket is still better than worthless in your pocket anyways.

You forgot the biggest piece of the pie! Trillions have been given directly back to the banks, via insurer’s bailout money! Hello…. all we are waiting for is banks to start buying ULTRA CHEAP ASSETS again, unloading hundreds of billions of dollars into the markets. The argument is clearly for INFLATION, not deflation. When treasury yields begin to rise, this is the clue that Big Fish is gathering cash for new positions.

Posted by Ben | Report as abusive

http://freepage.twoday.net/stories/53944 23/
Wednesday, December 17, 2008

The head of the International Monetary Fund has warned that advanced nations will be hit by violent civil unrest if the elite continue to restructure the economy around their own interests while looting the taxpayer.

During a speech in Madrid, Dominique Strauss-Kahn said that “social unrest may happen in many countries – including advanced economies” if governments failed to adequately respond to the financial crisis.

“He added that violent protests could break out in countries worldwide if the financial system was not restructured to benefit everyone rather than a small elite,” reports the Guardian.

Strauss-Kahn’s comments echo those of others who have cautioned that civil unrest could arise, specifically in the U.S., as a result of the wholesale looting of the taxpayer and the devaluation of the dollar.

Posted by John | Report as abusive

The heart of the matter is energy. Cheap energy sustained economic growth. As crude oil, natural gas and electricity prices climbed the economy began to falter worldwide. An economy that imports much of it’s needs will be held hostage to the ever rising cost of shipping and production. An economy that relies on imports for energy supplies, approaches a precipice when those products skyrocket in price as has been the case since hurricane Katrina. As the U.S. is a nation dependent upon individual transportation, the spike in petrol costs precipitated curtailing of discretionary spending. Where economists missed the boat is there was no initial drop in GDP. People have to get to work.

It is, in my view, unproductive to debate the nuances of fiscal and monetary policy unless the crux of the discussion is how to move forward the building of a 21st century green energy infrastructure. Energy should be a matter of national security and the focus on energy independence. This would also be the time to reevaluate our manufacturing capabilities and trade posture towards globalization. It is evident now that the disruption of one economy will have a serious impact on all others in this current global scheme.

Posted by Anubis | Report as abusive

NOBODY GETS IT YET ! It’s not about the Dollar, The stock market, Bonds, the FED or the Treasury. Its about the coming collaspe of the paper monetary system. Wake up ! The market is in control not the FED they are just delaying the inevitable and thats why nothing is working. Just wait and see . . . . . The market always has its way !

Posted by Swiss Gnome | Report as abusive

You guys can argue all day about this issue and that. Green energy? Have you done the numbers? 25% of all CO2 is produced by cows! If we did what they are wanting on autos, it would only be a 1% reduction. With Toyota’s Prius – it would take you twelve years to get your money back for the extra you have to pay for the car. There are over 9,000 scientist that are far more educated than the morons talking about global warming.

Our biggest two problems, are the government and people in this country managing their money no better than the FED. And how about the fact that the Federal Reserve is not a government entity, but rather heads of large banks?

Posted by Scott | Report as abusive

“Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.”

Control is not their intention. Ransacking the wealth out of America is.

Posted by Kim | Report as abusive

The problem has been well stated.

I think things are going to get nasty.

For a solution I tend toward gold and silver in all forms and guns and ammunition in all forms.

One post about green energy and you pick it. BTW, you are confusing methane with CO2. Autos are not the only focus, but rather the only thing you hear in the media. But I digress.

On topic, the end of the world is not coming. Manias follow manias. Those that choose to play end up paying/reaping. Look at the price of the 30yr (37 point above par). 24/7 coverage is feeding this panic. Its just time to pay the imaginary financial piper. There is a lot more to our economy than Wall Street and the FED. Once Wall Street becomes un-leveraged this will clear. FED will correct it actions when the environment calms.

Posted by Matt | Report as abusive

I command John for the great courage to spell out how the T-Bonds look so overpriced. Just a good way for the US Government to fund new debts at a very low cost. The $ is showing sign of weakness, the market will catch up that way, before interest will shoot back up again, if ever. Exactly like Japan, where the Yen stayed depressed for a very long time with over 10 years of low interests and counting.

Posted by Rob | Report as abusive

only way out of these mess is to creat employment by way putting more money in building and construction ,supportig agriculture and mining,making it easier for wealthy skilled people to settle in u.s.a ,supporting precion, high tech and heavy engineerig industry.buying more from third world countries especially africa.telling china and japan to set up industries in third world if they want their goods on american shelf.by making third world rich,u.s.a.will be richer.without employment americans have little confidence coming out of recession .

Nothing new about this story…

I predicted this 9 years ago
It’s all quite simple

It’s more or less Austrian school

But befor we see the Treasury Bubble collapse, we will see the credit card crunch.

The question is if the dollar collapse will be before or after the T-bill/bonds collapse

The question is what will the Chinese do them own more than 30% of US T-bonds.

Or better still when will the Chinese dump their
US T-bonds.

Anyway all will lead to hyperinflation beyond Weimar.

And before that the US will have martial law.

Posted by Jack Michigan USA | Report as abusive

We look at the result and think it is the cause!

Western Democracies with relatively free markets have been sending about 2 billion dollars a day to Totalitarian Dictatorships, for close to 40 years. Dictatorships that seek, and openly plan and teach this philosophy of hatred of Democratic societies. If you are wondering why there is suddenly a liquidity problem all you need to do is look at where the money has gone. To despots that want to use oil addiction, currency manipulation, violence and legal challenges to turn the civil code on its head. All to kill the very idea of democratic societies. Trade with villains and soon you become one or their slave. Not sure the policy of crashing western economies will change anything. It is not like these people are motivated by anything other then the complete destruction of the civilized world. So a rush to the bottom my not create a competitive opportunity. These Tyrants have been telling us for years that they wish to kill us, yet we still sell them the bullets, then are surprised when they shoot us in the head. You think it is about the money, they tell us “no it is about the gun I have pointed at your head”.

Posted by Think | Report as abusive

Americans should look at the FX market reaction to the latest Fed Ponzi pump-up and be very alarmed.
The downside risk of the USD far outweighs Treasury rates, as can be seen now that the deleverage selloff is running out of things to sell.

Posted by Survivor? | Report as abusive

When the economy bubbles in that way, it can only mean one thing, and that is that the united states of america is falling, it will never recover, ever, even if they manage to fix confidence because their is to much competition in the world and entire countries are running away from the dollar. The economy will send bubbles and eventually contract, their is no way of fixing it, the next bubbles will just drop the dollar to it’s true price, way lower than it is now because the entire U.S. economy is a ponsi scheme, it can’t even justify its own currency anymore.

Posted by Randal | Report as abusive

‘We have met the enemy and he is us!’ (Walt Kelly)

My captcha image is TOAST, much like the US economy.

Posted by Hahaha | Report as abusive

There seems a relatively simple analysis for what has happened; to wit, people borrowed too much (because of ill-considered stimulus by the Fed) and are now unable to borrow more safely. This means that they must now save and rebuild their balance sheets. That means decreased consumption, which will require recession. There is not another way out. However, Bernanke, Paulson and the Congress can make it much worse by increasing government debt which ultimately must increase the costs borne by taxpayers, making it harder for them to save.

Posted by John Goodrich | Report as abusive

When the stock market bubble burst in 2000, the Fed used the hard-earned money of prudent savers & investors to prop up an economy gutted by the greed of bogus asset appreciation & manipulation. It is doing the same again & forcing savers into speculation in order to get a paltry return on investments.

The housewife who makes ends meet each week on a limited budget is a far better econonmist than Bernake, Brown, the US/UK governments & economics professors etc., all of whom live by dipping their hands into other people’s pockets!

Posted by A Betts | Report as abusive

This “bubble” was caused by the current administration creating a 10 trillion deficit. As LBJ showed us, if you are going to war, pay as you go, or pay the consequences!

Posted by Walter Jenkins | Report as abusive

“December 17th, 2008
10:11 am GMT Basic problem–Keynes. His economic theories, still being used not only by USA but essentially by all major countries, were created in mid 1930’s and used by FDR. Read them and see how irrelevant they are for our world. We now are a global world Keynes could not imagine–airplane, television, internet, cell-phone, etc. Virtually nothing is made in just one country. So one-government solutions will not work. Where is our Adam Smith, Karl Marx, Keynes?

- Posted by Richard Gustafson ”
Dear Richard;
Adam Smith lives at Mises.org Read Murray Rothbard’s “What Has Government Done To Our Money.” Now you have found the only realistic school of economics that can be proven by correct predictions.
The book that dropped the scales from my eyes in 1971 was “The Law,” by Bastiat. It is my accepted moral duty to point out the perversions of the law by officers of that law.
The Federal Reserve System and fractional reserve banking must be returned to their pre-1913 condition, that is to be non-extant.
Enjoy your reading.

Two ways out of this mess. First a real honest to goodness war, not this part time war we see in Iraq. A real war would get the ecomony going great guns (parden the pun.) Assuming we don’t want that, the other way is to elect the smartest man in the world to be president. Thankfully we have done that and Pres. Obama will now save us of this I have no doubt. We must all trust him even when he raises taxes, spends trillions on bridges to who knows where, gives cash money to people who are too poor to pay taxes, allows every illegal in this country to join, and makes us all have govt. health care. In the end it will work and we will be the most loved country on the planet. Just say YES WE CAN everyone. YES WE CAN.

Posted by Bill | Report as abusive

DaveF is right, the economic system is unstable, just like a sound system turned up too loud, which screeches and howls. Or power steering gone berserk, where a slight twitch sends you all over the road and then into the ditch. The reason for this is very simple, computerized trading systems which feed on each other by placing automatic buy and sell orders according to some secret bogus formula. This sort of automatic trading should be banned immediately. OK, use computers to keep track of things, but buy and sell orders must be placed by a real person who is personally responsible for those actions.

Posted by Bill | Report as abusive

Taking a not so wild guess here.

1 – Rampage battle inflation – deflation
2 – Devaluation

The shadow banking system has created a 1,5 Quadrillion dollar massive sucking black whole. Total Bailout more than 8.5 trillion dollar but Bernanke needs at least 20 trillion dollar.

Sat no more.

Posted by Youri Carma | Report as abusive

Obama and his team are entering seat of power at worst time.
Fighting Deflation is going to be very diff task, lets not forget if current FED’s measures dont help, Cascading effects of deflation will put only US but whole world into deep troubles (Oh we alreday are in deep troubles).

Posted by Aasim Nisar | Report as abusive

Isn’t it interesting that Greenspan, Bernanke, & Co. deferred to the “wisdom” of the market when they made no effort to tame rampant speculation during the stock market and real estate bubbles and yet the FED is now quite certain that assets are priced well below “intrinsic” value and will thus do everything in its power to re-inflate these markets.

With artificially low interest rates and lots of moral hazard courtesy of the FED, Americans were duped into believing that they could spend every penny of disposable income and borrow against the next 30 years of income to buy their houses, SUVs, and iPods while the Chinese were doing the saving for us.

Well, that chicken has now come home to roost and the only genuine solution is for Americans to begin saving once again allowing for capital formation and productive investment at home. Yet Bernanke will not allow this; with zero interest rates, he is destroying our incentive to save in a desperate, manic, and misguided effort to re-inflate the credit bubble and coerce households back into the consumption rat race. THIS IS IMMORAL!

Posted by FinanceDoc | Report as abusive

Phil Pellerzi wuz hear – this is a good one, you should read it

it seems to be the last step in the global scam as the US government consolidates money to itself. I knew this was comming but my lack of technical knowledge betrays me on a regular basis. Thank you for pointing out the mechanism by which the US government ponzi scheme of the bush administration will be playing out its end-game

pay back to ceasar what is his:

we will now make the rest of the world pay for our infrastructure improvements and new energy economy by incurring massive debt (check) – creating a situation whereby that debt looks good to buy (check) – spending that money on high yield internal investments for the impending 30 year economic boom the US will enjoy (i called it) – the period of deflation will yield to inflation and we will inflate our way out of debt while the rest of the world loses all the fake money we gave it.

but it isn’t so bad as i make it sound. the rest of the world got a whole lot out of the bargain (civilization) and will continue to reap ever greater benefits as members of the international pyramid – GO WORLD!

but really: i don’t know much and maybe i am way off base

pellerzip@sacredheart.edu

These policies assume that there are people out there willing to soak up cheap credit if they get access to it. But credit offtake will happen and economy will recover only if the demand is kept up. How to do that, government is in the best position to decide. Support the industries however ineffecient they may be, it cannot afford to let Chrysler and GM to go belly up. There is no way out but to prop these behemoths, or else there may be another chain similar to the one which started when Lehmann was allowed to collapse

Posted by TS | Report as abusive

Having recently studied economics, I can tell that all they are doing is destroying value. Growth is certainly attained by stimulating demand but the market can also price assets independently and should certainly allowed to do so for the better of us all.

Posted by edoardo | Report as abusive

While Guru’s like Bob Prechter feel we are in a massive Deflation/Depression I am unable to understand how it can be so.If Central Banks print Currency and circulate it by Buying junk Assets and other Expenditures,I can see only Inflation on the horizon.Also if GDP Growth is just 2 or 3 % and Money Supply is increasing at around 20% we not only get Inflation but massive Bubbles in the near future.
In the Developing World where I live the argument for debasement of Currency is so strong that all Cash is deployed into Assets(Stocks,Agricultural Land,Commodities,Gold) even if they are ridiculously overpriced.The value of infertile barren Agricultural land within 100 miles of any Metropolitan city in India has appreciated around 1000% in the last 5 Yrs.
Something is wrong somewhere and it stinks.Bernanke and Paulson’s talk looks like bluff and bluster to me.These guys seem even more clueless than we are.Sure Stocks look cheap but where the Hell are Earnings going to come from?Are we by any chance following in Zimbabwe’s footsteps?Is it possible that value of Financial Assets plummet and Hard Assets skyrocket?Buying US Treasury for zero yield,are these guys loony OR Geniuses?
Questions,Questions and Questions – No Answers.
Hope we dont get the Answers after becoming Paupers!

Posted by F.Daruwala | Report as abusive

Great analysis. It certainly doesn’t take a degree in rocket science to realize that excessive and cheap credit creates bubbles which creates crashes, so why has the Fed, Congress and the Exec Branch found it so hard to recognize the endless feedback loop they have created?
We had a fractional reserve banking system that worked and allowed for orderly economic expansion that recognized risk and assigned relevant cost to credit. Somewhere a political feel good, no pain ever philosophy crept in to economic decision making, and as a result we trashed the system through repeal of Glass-Steagall and runaway power at the Fed, combined with idiotic deficit spending at all levels, and now, under the umbrella of crisis management we are allowing the Fed and Treasury to write a new paradigm that legitimizes securitized debt and a whole slew of other uncontrollable instruments and processes.
These economic oscillations are coming closer together and swinging wider and making Kondratiev’s grand super cycle theory look very credible. If we don’t get the reigns back in responsible hands, the future looks very ominous, both economically and socially.

Posted by Gary Leeper | Report as abusive

I certainly have a lot of sympathy for bond investors and other lenders who theoretically have a 100% chance of losing money. If rates are at 0%, obviously any increase in the rate reduces the present value of the loan or debt asset. I also feel sorry for the economy since this move by the central bank absolutely kills financing – unless somebody can tell me why a lender wants to lend money if he gets close to nothing in return. It would be better to hold cash. I really think Homer Simpson is operating the central bank – first through Greenspan and now Bernanke. We can probably get a more enlightened response to this financial crisis from a hamster.

I also want to point out, because it seems like these economists need a bit of help figuring stuff out, the ability for ordinary people to pay for debt is linked to profit margins. This directly true in the private sector and indirectly through in the public sector. Salary levels are fundamentally related to the ability of a company to pay through profits. We are supporting industries and sectors with shrinking profits and higher levels of efficiency. So we can try to engineer recovery by borrowing or printing cash. We can take money from my line of credit, spend it on roads, and then send me a bill. My ability to pay has not actually improved. The only difference is I have much more debt. Intentionally causing inflation during these times is like a poison pill.

So I think Bernanke should cut down on the shrimp cocktails and stop messing with stuff he has not figured out. And for the rest of you chumps holding onto equities with the lending rate at 0 percent, that takes a lot of guts. Really I am impressed. Make sure to give your investment advisors nice bonuses this year.

Posted by Don | Report as abusive

From all indication; these financial moves were deliberately done to eventually bankrupt the corporations and even the Stock Market which will probably crash in 2009, as the super rich will be making a killing and buying these stocks and properties and corporations for nickles on a dollar. And then to further their total control and rulership; the 2nd Great Depression is on its way to finish the draconian onslaught!

Posted by Rev Reggie Jackson | Report as abusive

Giving the addicts more dope, see the parallel?
Guess who the drug dealer is?

Posted by defeht | Report as abusive

I have a hard time understanding the deflation scenario as well, while the printing presses are rolling 27 hours a day. But for whatever reason, deflation is happening right before our eyes. I shorted gold today while in the back of my mind I feel it should be worth $4,000 per ounce.

So I get it now! Deflation first until as much debt is paid as possible. Then inflation once the world realized all the $USD are worthless. Yup… that’s it. We’ll probably see $600 gold first, then $4,000 gold. I got it all figured out now.

And all this courtesy of Greenspan and Bernanke who work for the Fed which isn’t even American. The Fed isn’t federal and it isn’t a reserve. It’s a foreign owned private bank. And whoever ultimately owns the fed (trust me, they aren’t Americans) knows full well what they’re doing. They’re making certain that ultimately the $USD will collapse like the German mark did. Get ready to fill up your wheelbarrow with cash to buy that loaf of bread. And don’t forget to buy that gold… but not right now. Wait for the deflation to finish, then buy the gold. Yup, that’s the ticket.

Posted by Albertarocks | Report as abusive

[...] Fed unleashes greatest bubble of all [...]

Being relatively new to the investment game, I am experiencing a very steep learning curve in these times. I always had faith in the leaders of our economies because I respected people that I thought knew more about these things than myself. My view has changed. This train wreck was easy to see and should have been avoided. And now that the situation has been allowed to deteriorate to this point, the Fed is trying to re-act when they should have been anticipating 18-24 mo.s ago. Now, the Genie is out of the bottle and won’t go in without a fight. The sooner the market has a chance to work thru all the problems that have been created, the sooner we can get on the other side of this and move on. Hopefully, this will happen before total Armeggeddon.

Posted by Putz | Report as abusive

Please help me understand something. Would the economy and the financial markets unravel as they have if The Fed did not raise the interest rates 17 times after keeping rates low in ’01-03ish? It seems to me that this was the epic center of the turmoil.

It was one thing to bring rates down low in ’01-’03 to avert a financial meltdown but what about raising the interest rates unmercifully 17 times after that? The likes of which eventually left many adjustable rate (prime and sub prime mortgages) written by the ship load to fail. (A 500k mortgage went from 2k ish a month to service to 3.8k ish) On what planet was it a good idea to kill the real estate market to keep the price of a loaf of bread down? (Oh, excuse me, that would be on Planet Hedge Fund.) The Fed chose an outdated method to tame (slay) Global inflation of the day. The raising of the interest rates had no bearing on the price of bread or oil for that matter. What a “freaking” expensive lesson — where we have to see the financial markets unravel, then socialize with little haste and for the world to head into Great Depression II to realize this silly/horrific game? Where is the protection for the people? Where is the concern for their homes? The real Moral Hazards are the greedy Dukes of Derivatives and theFed driven by the banks. And what about the guys that sliced and diced mortgages into credit default swaps (or whatever) then double and tripled insured them? Once those mortgages failed the investors gained double and triple the value of the property in insurance (plus the property????) breaking the likes of AIG. One commentator noted on CNBC it was like “taking an insurance policy out on your neighbor and then running him over while he stood in the driveway.” Another NY columnist noted that these were “the real weapons of mass destruction.”
This will not correct until the real estate market is healed. This arrogant comedy/tragedy of errors has broken the back of the American consumer (who are 2/3 of the domestic economy and the economic engine of the world-despite what they say about China!) Don’t get me started about the consumer –don’t blame them for using their homes as piggy banks when the facts show that real incomes for regular people have not increased since ’00. While Joe the Hedge Fund Manager enjoyed his gilded billions and Joe the CEO and Joe the CFO of many a public companies enjoyed exaggerated mulit-million dollar compensation packages, not a penny trickled to regular folk. Why did they do it? That is to say, why did the Banks, The Fed, The Hedge Fund managers, the CEOs, the CFOs, the investment bankers, the insurance companies do it? — because they could.

With crony capitalism and rabid, foaming at the mouth financial instruments that can bring the world financial system to its knees — where are the free markets? Cartel controlled oil prices, aristocratic corporate heads, subsidized millionaire farmers, crony capitalism described by Greenspan, apparently that’s all part of our so called free market– but pulleeze don’t even think about helping those who signed up for adjustable rate mortgages — partisan politicos would have you believe they are pond scum and that they deserve to lose their homes. Let the market forces bear upon them (but not banks and insurance companies) and reap the winners and losers. For those that are familiar with the film “Caddy Shack” Chey Chase tells Bill Murray “there’s a pool and a pond, the pond (and in this case the toxic, rabid, foaming at the mouth pound is for you, you filthy adjustable rate mortgage holder, you deserve to lose your savings, home equity then your home!” This is nonsense. Someone has to start talking sense.

While partisan politicians bemoan the transfer of wealth through taxation, they approved the biggest levy on the American public (aka 700 billion dollar bailout) thereby transferring the future pittance of wealth of Amerca’s regular folk (and their children). Critics now say this will only temporarily bandage the wounds caused by the rabidly greedy.

Posted by Marie Barry | Report as abusive

OK, either Greenspan, Bernanke, Paulson, Cheney, Bush, et al are total morons who idiotically are inflating one bubble after another or…. maybe this is the final takeover through a destabilization strategy. Only those aware in advance of the strategy know how to keep their powder dry. Then when everything deflates to negative values, they rush in like vultures gorging themselves on the dead and dying remains of once prosperous societies. And while this is going on everyone calls them morons instead of criminals. And nobody realizes what hit them. They take it all and for some reason nobody is held accountable. A great Hollywood movie scenario except that no one would believe that they could get away with it.

It has been said more than once that nobody ever went broke underestimating the intelligence of the American people. Clearly it is not only the American people who seem to be mired in myopia.

Posted by Jonathan Cole | Report as abusive

It would be interesting to see if there are any companies left on the S&P that would be able to turn an acceptable profit if it wasn’t for the leverage they used to achieve it. I bet that if all debt in these companies was swapped for equity, the return on equity would be minimal. Hence, cheap debt has been the only way to avoid complete bankruptcy of the industrialised world. In fact – capitalism is dead.

Posted by Arie | Report as abusive

Listen up because I was deliberately sent to this thread for a single purpose. I have a message.

Never forget the gifts of the Magi.

Gold’s only historical problem, as money, was never about gold. It was simply the poor liquidity and poor logistics of the systems that supported gold as money.

Imagine gold as a store of value as money where we each have global reach and instant liquidity, transfer of allocated title and there is no debt.

Instant liquidity, store of value and no debt. That’s all we need.

Gold backed digital currency solves the liquidty issue for gold. Support them.

You cannot pour new wine into old wineskins …. so true.

The Feds are painting themselves into a tighter and tighter corner. As of now, only the Feds are able to borrow money,(thank-you China),as America’s citizens, many of it’s companies,all of it’s banks and financials,all of it’s cities and states, are basically insolvent. This results in a continued line up for bail-outs, because the Feds are still able to borrow and print money. The problem arises when the world stops lending to the Feds. In Jan. 09 the Feds have announced $330 billion in treasury auctions to repay foreign Central Banks, plus the usual $150 billion in auctions. Who will be buying? Will the US be facing a serious test of rolling over their debt? If US bonds fail to sell, rates will be forced higher, alot higher. Then the Feds will have to print trillions to repay debt. Cause and effect..First, bond failure, then currency failure..

Posted by Bull Run | Report as abusive

Possible help for housing market — 

”Heal thy neighbor”
Emergency measures are needed to prevent more damage to the economy caused by the Fed raising interest rates 17 times in a row before drastic reductions this past year. The Government should first isolate adjustable prime and sub prime mortgages (and include conventional mortgages as they began to default and before they fall off cliff too) and offer mortgages direct to homeowners as follows: extended to 30,40,50 and 60 year terms — basically to keep money flowing and mortgages serviced. Rates should be as low as 1% (like those offered to the banks whose pipes are now clogged with taxpayer billions). For those homeowners that were able to make it thus far, this might be the safety net needed to prevent economic death and undo reversal of equity and drainage of homeowner capital caused by The Federal Reserve Banks. The net effect is the Government will make the homeowner whole again and mitigate the damage caused by The Federal Reserve Banks. It may even stir the real estate market out its Fed Induced coma.

Posted by Spark 123 | Report as abusive

The fed is stuck, They have to keep rates low to allow as many as possible holding Alt-A and Option ARMs mortgages to refinance before their loans reset. They can’t raise rates or a greater percentage of these will default. The subprime loans were about 1 trillion, the alt-A and Option ARMs represent 1.5 trillion. The worst is yet to come in real estate.

Posted by Joe | Report as abusive

In simplest of English: centrally planned economies, with centrally planned interest rates, do NOT work! Liberty writer

Excellent analysis

The reason japan couldn’t rise rates is exactly as described.

As the world lapped up on carry trade during early nineties
there were lots of long yen positions which would go horribly wrong if the interest rates went up

Infact that could have been the cause for asian crisis when there was huge dollar outflows out of Asia

Japan cannot raise rates even now because of this

So the spiral of destruction is irreversible and most economists are clueless

Rapidity of the destruction has surprised everyone but this is the gift, markets on the wire, have brought

Posted by madhukar | Report as abusive

John, nice analysis. I believe the FED and Treasury might get lucky in stabilizing our economy simply because world wide markets think they to are falling into a severe recession. As soon as Europe and Asia realise that their currencies and governments are actually where real stability lies, then the treasury bubble will burst.

I am banking on the residual psychology of Europeans and Asians too distrust their own banks and governments more so than ours. I will go short on long treasuries when I think they are getting wise to the Fed’s Wizard of Oz tactics.

Posted by SOF | Report as abusive

Part of the problem is that the Treasury cannot print money fast enough to support the house of cards the Fed has created. The Treasury should have the Chinese print our money because the labor is cheaper and they have plenty of unemployed workers who would love to do the work. In return we could have them print a few hundred million more than what we require so that they could be compensated for their efforts. Another possible solution may be to give everyone access to the standard image files used to print our money so that everyone can simply download the images and print their own money. This would give the unemployed people in the US something to do while providing liquidity for the Fed. The cost of the toner and paper would have to be absorbed by the individuals who prefer to print their own money with the possible exception of individuals who cannot affort the supplies necessary for printing; in which case they could either bill the Treasury for their various expenses. For those individuals whom do not possess the computer and printers required to do the printing, office supply stores have very good printing capabilities are very fast and take individual orders. The enthusiasm with which this enterprise would be undertaken, by all concerned, may create a shortage of toner and paper but with everyone printing their own money there would be plenty to go around. This approach is certainly more equitable for the individuals at the bottom of the ladder with the exception that at present the Treasury prints the money for the financial institutions whereas the majority of the little people would have to print their own. In order to equalize this anomaly the Fed would have to start charging a fee to financial institutions for accepting Treasury printed money. Fair is fair.

Posted by Emile | Report as abusive

Good analysis. Bernanke came in raising rates, I want that guy back. All these giveaways to the big, idiot banks, is driving me crazy, it solves nothing, arguably makes it worse – which is the hidden message in this column.

Posted by Justaguy | Report as abusive

Joe, the people in trouble will not be able to refinance for lower rates. They are underwater. No bank will lend to them.

Posted by Kirk | Report as abusive

Houses are the problem.What to do?Provide that upon aproper showing of hardship a mortgagor need only pay 31% of his income TARP will make up the difference to the mortgagor.As the HOLC did there can be some ways to give the mortgages HAIRCUTS etc. etc..

Posted by art byrne | Report as abusive

I think the whole matter is repeatedly missed. Obama won’t do much other than absorb some of the vaccuum that has naturally developed when an economy becomes generationally overleveraged. The 2.5% on bonds isn’t a bubble unless the dollar and the US government lose international support, then 10% would have been a bubble. The Fed gets too much credit, which is why we are in this mess to start with, the enduring belief that the Fed controls the economy. The level of debt and the factions involved in manufacturing debt are more important than the Fed. It was the Wall Street, FNMA and Freddie Mac money machine that created all of this. The method of securitizing real estate through new means that weren’t tested over decades, but instead under theory built this death machine. Even the nonsense that China saved money and built this mess is in error, because it was the money machine of the mentioned parties that did so. The 1990′s were the advent of this type financing, not this decade. People naturally move to bonds and this is not a short term move. I think most of us are shocked that Japan has maintained rates under 2% for well over a decade, despite its central banks attempt to destroy the currency. We are in for a long haul and those that think 2.5% on 10 years is a bubble also thought 4% was.

Swinge them rates!

Or buy a spellchecker. Either way works.

Posted by Sean | Report as abusive

Mr. Kemp, The following facts in no way negate the validity of your column. They compliment the tree focus with forest facts.

1. The rise of every empire is predicated on Capital productivity: standing armies, bronze, navel fleets, communication. These bubbles – focused resources – fuel expansion – growth.

2. The fall of every empire is proceeded by Capitol contraction: protracted non Capital profitable ventures – usually war: Greece, Rome, France, England, Russia. These have no Capital ROI when there is no Capital to gain.

3. The use of a fractional reserve system is a built in governing control, which the Central Bank does not have.

The Tech bubble fueled by productivity enhancing devices and the RE bubble fueled by diverted focused resources triggered by Greenspan’s irrational exuberant fear of… productivity – it’s alarming. Raising the cost of Capital until the economy is erotica asphyxiated to near death then lower the cost of Capital to create what? A salvage economy wave.

The grand experiment seems on it’s last throws, but ‘there’s GOLD in them there hills’ and from one surfer to another “See You On the other side bro” –Just Riding the Lightning

Posted by jacksonroy | Report as abusive

The root of our problem is that our government has been corrupted by unchecked corporate influence.

Resulting in huge numbers of both legal and illegal worker importation and blind obedience to free trade/off shoring.

Our government has implemented H-1B, and L-1x visa programs by which corporations have imported several million foreign tech workers, displacing millions of highly paid US workers and depressing wages millions who remain in the field.

These worker import programs have rapidly depreciated several trillion of dollars worth of US worker education and investment. We are now seeing the consequences of that loss.

Along a similar vein. Illegal immigration has displaced millions of US citizens from lower skilled, once well paying construction jobs. This has driven up social costs, (crime, medical, education), while depressing wages & revenues which support our social systems.

Free trade for the most part is only mutually beneficial when trading among equals in terms of social progress.
(Social security, labor unions, min wage, overtime laws, medical, Workman’s comp, etc.)

Until these society killing market distortions have been mitigated the US has NO CHANCE of a recovery. Have a nice day.

Posted by Tim K | Report as abusive

I talked to an investment banker the other day who works at a major U.S. bank. He felt that maybe the only way our government can get out of it’s debt situation would be for it to inflate it’s way out of it. Eventually inflation would cause our Gross Domestic Product to increase to a point where the national debt would become smaller and smaller relative to our GDP. But now with the democrats talking major government stimulus, this would increase our national debt even more. First the Capitalists(The Republicans) give away tons of money to the banks, and soon the Socialists(The Democrats) will probably give their “New Deal” money away. Obviously both sides are instilled with a kind of Yankee optimism that suggests to themselves that they can grow the money supply to any heights they desire in what they view as the most liquid and indestructible economy in the world.

Posted by John R | Report as abusive

I cant help but read the hundreds upon hundreds of posts much like the ones on this board claiming the ultimate bankruptcy of the largest economy (and largest tax base) in the world. There is no doubt that the housing bubble represents the largest challenge facing the U.S. since the second world war as far as hardships are concerned. However, any student of economics and history for that matter will take note of the real effects of fiscal stimulus. Yes the national debt has skyrocketed with the bailouts, but a bankrupt country’s debt will not be issued at less than 1% rates. Are these rates artificially conceived? Maybe, but no less real. And inflation really is of no concern at this point. I would hope for some inflation right now as this would certainly drive some of the loads of cash into assets that protect inflation- stocks, commodities and could possibly stabilize housing prices somewhat. The Chinese have benefited in terms of relative economic power. But it has not and will not successfully decouple from a strong relationship with the U.S. As for the goldbug survivalist crowd- it has proven to be an historically wrong sided bet against the collapse of civilization. Sure things have changed, but countries adapt and do not collapse within a framework of a few financially troubling years. Britain successfully re-engaged with a globalized world following the second world war and their dissolution of the world’s superpower, as the U.S. will most certainly do in the coming years. However, the U.K. still remains and economically and politically to this day even after the “collapse” of their empire. We will spend less – probably good, be a world leader- Obama is good start, and we will quite possibly looked upon with amazement in the years ahead that we were able to “print” our way out of this mess.

Posted by David | Report as abusive