The Next Bubble

Here is a key bit from an interesting article by Steven Pearlstein in the Washington Post. He points out that the Bush/Obama financial maneuvering is setting us up for another big bubble and crash:

Less encouraging is what's happening on Wall Street. It turns out that all those bold and necessary steps by the Federal Reserve to prevent the financial system from collapsing wound up creating so much liquidity that it has now spawned another financial bubble.

Let's start with the $1.45 trillion that the Fed has committed to propping up the mortgage market -- money that, for the most part, was simply printed. Effectively, most of that has been used to buy up bonds issued by Fannie Mae and Freddie Mac from investors, who turned around and used the proceeds to buy "safer" U.S. Treasury bonds. At the same time, the Fed used an additional $300 billion to buy Treasurys directly. With all that money pouring into the market, you begin to understand why it is that Treasury prices have risen and interest rates fallen, even at a time when the government is borrowing record amounts of new money.

As it was printing all that money, the Fed was also lowering the interest rate at which banks borrow from the Fed and each other, to pretty close to zero. What didn't change was the interest rate banks charged everyone else. As a result, "spreads" between what banks pay for money and what they charge are near record highs.

So who is borrowing? By and large, it's not households and businesses, which are reluctant to borrow during a recession. Rather, it's hedge funds and other investors, who have been using the money to buy stocks, corporate bonds and commodities, driving prices to levels unsupported by the business and economic fundamentals.

The excess liquidity is even being used to finance a new "carry trade" in which global investors borrow at U.S. rates and buy government bonds in places like Australia, where prevailing rates are higher. Because the carry trade involves exchanging dollars for foreign currencies, it has been a major contributor to the recent decline in the dollar.

Naturally, this has been a blessing for Wall Street's biggest banks, whose trading desks have not only made big money executing and financing the investment strategies of others, but have also been trading actively for their own accounts. And with bubble profits come bubble bonuses.

Back at the Fed, the attitude has been to welcome anything that strengthens the balance sheets of banks, particularly while they continue to write off billions of dollars in soured loans each quarter. Nor is the central bank in any rush to begin pulling back from its current policies. Citing the mistakes made by their predecessors during the Great Depression and by the Bank of Japan during the "lost decade" of the 1990s, Fed officials are determined not to snuff out the economic recovery by moving too early to raise interest rates and reduce liquidity.

But the lesson I prefer to focus on is the one from this decade, which is that central bankers ignore financial bubbles at their peril. Given the new architecture of global finance, the Fed can no longer think of its job solely in terms of the trade-off between inflation and unemployment. Nor should it become complacent about restrained consumer prices while ignoring rapidly rising prices for financial assets. As Alan Greenspan discovered, it is also a mistake for central bankers to assume that they can quickly sop up excess liquidity whenever they decide the moment is right.

Alan Blinder, the Princeton economist and former Fed vice chairman, may be right when he says it's too early for the Fed to begin raising interest rates. The economy is still too weak, he says, the threat of deflation still too real.

But it is certainly not too early for the Fed, at the conclusion of its meeting Wednesday, to warn Wall Street that its current policies cannot, and will not, continue indefinitely -- particularly if the money is used to inflate bubbles rather than finance real, sustainable economic growth.

I worry about inflation. It is a tax on everybody who lives within their means. The only people who benefit from inflation are those holding debt since they can replay loans with inflated dollars. Meanwhile, the government is fighting this current financial crisis using a hidden tax on everybody who holds financial assets. By keeping interest rates artificially low to allow banks to make profits to climb out of the hole they created for themselves, it taxes the rest of us by denying us the income from our savings that we deserve. Instead, we are being taxed both through federal spending and indirectly through the artificially low interest rates on our savings. All this is being done to make whole the malfactors who created this problem. They get no punishment. Instead they get rewards. While the average Joes, who had no responsibility, are paying both through taxes and through a hidden tax to put money into the pockets of the bankers who created the problem. This is evil.

It may be needed in the short term, but it should be openly acknowledged. (Where is all that "transparency" that Obama promised?) The government should make known what it is going to do to punish the evil doers and how quickly it can stop punishing the innocent with this two-handed tax grab.