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.


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.


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.


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.


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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