Monetary policy implemented by central banks around the world creates the conditions where investors inflate asset bubbles by chasing yield.

We hold these truths to be self-evident

Those are the first words of the US Constitution. Along with equality and inalienable rights, we could add another self-evident truth: the federal reserve causes asset bubbles.

Can We Blame the Fed for Asset Bubbles?

Apr 14, 2015 4:18 PM EDT, By Megan McArdle

On Monday, my Bloomberg View colleague Mark Gilbert explored a fretful question: Are we in the midst of yet another asset bubble? Stanley Druckenmiller, who helped George Soros “break the Bank of England” in 1992, thinks we are. In a speech earlier this year, he said he’s got the same bad feeling he had in 2004. The culprit is the same in both cases: the Fed, blowing asset bubbles, beautiful asset bubbles, with excessively loose monetary policy.

Gilbert ably summed up Druckenmiller’s remarks and the reasons to be worried about frothy asset prices, so I won’t try to replicate his fine efforts. Like Druckenmiller, I think there’s evidence that investors are “reaching for yield,” pushing into riskier investments in an attempt to reap the higher returns they got used to.

This is exactly what investors are doing, and they wouldn’t behave this way if the federal reserve hadn’t lowered the federal funds rate to zero and flooded the economy with cash. Too much money chasing too few opportunities is a recipe for mal-investment and asset bubbles.

Instead, I’ll focus on a different question: How much is the Federal Reserve really to blame?

Who else could possibly be to blame? Nobody else has the endless bucket of cash required to push interest rates up or down at will. The federal reserve printed nearly $4 trillion — that’s trillion with a “T” — to inject money into the economy through bond purchases that lowered yields to zero. Not even Warren Buffet has $4 trillion at his disposal.

It is received wisdom among many Wall Street professionals — and the majority of conservatives of my acquaintance — that the Fed’s monetary policy is capable of producing massive asset price bubbles. And it did so in the late 1990s in the stock market, then again in the housing market.

The federal reserve was more involved in the late 1990s stock market bubble than they were in the housing market bubble. The stock market bubble was caused by excess liquidity in the system as Alan Greenspan freaked out of Y2K, but the housing bubble was not inflated by excess federal reserve liquidity. The lowering of mortgage rates may have served to precipitate the bubble, but the actual effect of lower rates only accounts for 10% to 15% of the rise in house prices. The remaining 85% was due to toxic loan financing, particularly the Option ARM.

Many charts have been made juxtaposing the Fed funds rate and the S&P 500 or the Case-Shiller index. I expect many more will be produced in the years to come. But I am not sold on the value of these charts, because they don’t give me a mechanism. How does mispricing a single short-term interest rate cause investors to go mad and start wildly speculating on stocks and housing loans?

Her lack of understanding of basic economics is embarrassing. Mispricing short-term interest rates forces investors to abandon long-held investment criteria because no opportunities make the grade. Investors must lower their standards in order to deploy their funds or they end up sitting on piles of cash earning nothing. This problem is exacerbated by the federal reserve when they flood the economy with cash. The problem is so bad that most commercial banks leave this cash sitting on account at the federal reserve.

I’m not arguing that there is no effect. There is obviously some, because debt markets are connected. People borrow short to lend long all the time (that’s how your bank makes money — your deposits are essentially a revolving credit line that can be withdrawn at any time). When the Fed engages in open-market operations to manage the supply of money, it changes the market’s supply of government bonds. All these things have ripple effects that are felt across many asset markets.

Someone must have explained to her the basic mechanizations because everything she states above is correct.

But the case for placing most of the blame on the Fed seems to assume that these ripples are more like tidal waves, swamping any other considerations, such as whether those dot-com companies are ever going to make any more or whether people are going to be able to repay those mortgages you just underwrote. That seems extreme.

Whether it seems extreme or not, that’s what happens.

To put it another way, as I’ve remarked from time to time, if financial markets are really so stupid that keeping the Fed funds rate too low can cause the majority of investors to lose their minds and start pouring money into stuff that is unlikely to ever return their capital, much less a profit, then conservatives are wrong and free markets don’t work, and we should just abandon the whole project.

Duh! Wake up! We abandoned free markets several years ago when the federal reserve took control of the entire economy. What we should abandon is the federal reserve’s control of the economy through flooding capital markets with cash it doesn’t want and can’t use effectively.

Ben Bernanke himself made this point in a 2012 speech. Of course, he would say that, wouldn’t he?

No kidding?

But he made some other convincing points — noting, for example, that the housing bubble was international and seems to have started building in the late 1990s, when Fed policy wasn’t all that loose.

There isn’t much convincing about that statement because it’s factually erroneous. The US housing bubble began inflating in 2003 when toxic loan products became the norm. Most countries around the world embraced some form of financial innovation that proved so disastrous here, and they suffered the same dreadful results.

Yes, Fed policy is very powerful in the global economy, and maybe (probably?) threw fuel on the fire. But is it really so powerful that it dominated loans made in other currencies whose central banks were running tighter monetary policies? This seems like a stretch.

She fails to understand the mechanism here. When the federal reserve lowered interest rates in 2001 and kept them there for several years, investors sought more creative way to find yield. They embraced any investment opportunity that appeared to provide a superior return for the perceived risk. Mortgage loans looked safe; after all, house prices only go up, so toxic loan products offering superior yields were eagerly embraced, and the flood of money through these toxic loans inflated house prices. The federal reserve didn’t directly cause the housing bubble, but they certainly did create the conditions that fostered it.

But what’s the alternative explanation? Bernanke hinted at it in his speech: global capital flows, or what he has called the “global savings glut.” Too much money is chasing too few investments.

I always cringe when I hear this described as a global savings glut. It was a global liquidity glut caused by loose monetary policy. The results were the same: too much money chasing too few investments, but it wasn’t because prudent citizens were saving too much money.

Perhaps these flows can be increased or decreased by government policy, but they also have a strong, independent life of their own. They may get some help from the Fed and other central banks, but they don’t necessarily need it.

Central banks like the federal reserve aren’t necessary for asset bubbles, but loose monetary policy makes them easier to inflate and much more common.

For now, I’ll just note that even if Bernanke is right, that still doesn’t mean that Druckenmiller should be any less worried. Two bubbles in a row is troublesome. If we’re indeed in a third, that starts looking more like a trend — and not a good one.

What it does mean, however, is that we don’t necessarily have great tools to fight an emerging trend. Blaming the government posits an easy policy solution: Stop doing the stuff that is causing the bubbles.

Yes, this is exactly what should be done. As long as we live in a world where private savings have no value and where the central bank provides unlimited amounts of investment capital at whim, then we will have frequent, painful asset bubbles.

But if an excess of global savings over global investment opportunities is the main issue, what exactly are we supposed to do to stop that?

An excess of global savings is not the problem, so if the problem is defined improperly, then any solution derived will be ineffective. If the problem is defined as a global savings glut, the remedy would be to lower interest rates below zero to disincentivize saving — which some kooks suggest. The evidence of the last several years shows this is clearly not the answer.

We need to restore value to private savings by allowing interest rates to rise. If interest rates on savings were at reasonable levels, all other investments would pay higher yields, and the distorting effect of zero percent interest rates would not cause a string of asset bubbles. Unfortunately, given the deflationary pressures of trillions in bad debt still lingering in the economy, and given the excessive debt burdens carried by most families, raising interest rates simply isn’t possible right now — and it may not be for the foreseeable future.

Realistically, when you contemplate where we are in financial history, we are embarking on the great era of financial bubbles caused by loose monetary policy. These bubbles will dominate the financial landscape for the next few decades. The financial elites and a few lucky or wise investors will profit from the unnecessary volatility, but overall most will suffer until we put a stop to it.

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