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From Bust to Burst – by Vasko Kohlmayer

Posted By Vasko Kohlmayer On November 19, 2009 @ 12:00 am In FrontPage | 2 Comments

A Reuters story titled “Wall Street jumps on renewed risk-taking after G20” touches on a startling fact: a recent summit in Scotland of finance ministers and central bankers of the G-20 countries gave impetus to another binge of risk-taking on Wall Street.

How can this be? How can a gathering of the very people who have pledged to rein in Wall Street’s reckless wheeling-dealing inspire the very thing they seek to curb?

To understand it, we need to look at the meeting’s resolution. In their final communique, the participants jointly agreed to continue with stimulus measures in order to support what they see as a fragile recovery:

The recovery is uneven and remains dependent on policy support… To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured.

To coincide with the summit, the International Monetary Fund (IMF) issued a report intended to lend further credence to the central bankers’ strategy. Its premise is contained in this statement: “Premature exit from accommodative monetary and fiscal policies could undermine the nascent rebound.”

As most people know, those “accommodative monetary and fiscal policies” consists primarily of near-zero interest rates and massive cash injections into the economy. What the G-20 meeting did is, in effect, guarantee for the foreseeable future the availability of cheap loans and easy money. This makes for a temptation to engage in unhealthy risk-taking, because it invites Wall Street to take out cheap loans and then invest the borrowed money in assets that promise a higher rate of return. The difference is profit.

The problem with this is that the glut of cheap money pushes the trading price of assets into which it flows beyond what is warranted by economic fundamentals. The recent run in the stock market is an example of this. Many observers have been puzzled by the sharp rise in the price of equities in light of the difficult situation we find ourselves in. Given the economic realities, there is simply no way stocks should be going up that fast. The main reason behind their rapid rise is the ready availability of easy money. What this means, however, is that there is another bubble forming right before our eyes.

But stocks are not the only asset class that has been posting large gains in recent months. In his recent piece in the Financial Times, Nouriel Roubini notes that there has been a “massive rally” in assets across the spectrum. Oil, energy and commodities have all participated. Observes Roubini: “Asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.”

This incongruity cannot last forever. The prices of these assets will continue rising as long as investors have access to low interest loans. But sooner or later central banks will have to raise interest rate. Once that happens many borrowers will be forced to sell in order to cover their loans. As many people unwind their positions, assets will lose their artificially inflated value. Falling asset prices will then likely trigger a stampede with investors seeking to cut their loses. This will result in a rapid drop of value and we will end up with another bust.

The underlying mechanism will be similar to the one that led to the bursting of the housing bubble, an event that was triggered by the Fed’s raising of interest rates. This time, however, the bust will affect several asset classes simultaneously. That the burst of this multi-headed bubble in a shaky economic environment would have devastating repercussions goes without saying. This time, however, there will be no money for trillion dollar bailouts, since governments have already maxed out their credit cards. The next big bust can well bring the whole system to its knees.

But notice the cause of the predicament which lies with the government. In an effort to keep people content in their credit-funded lifestyles, our political and monetary elites have kept interest rates unnaturally low. As they do so, they unwittingly inflate bubbles whose subsequent busts wreak havoc across the economy. For well over a decade we have had unsustainably low interest rates which created an illusion of abundance and prosperity, but in the end we must pay the price. First it was the high-tech bubble, then it was the real estate bubble and now we are seeing the formation of a giant multiple asset class bubble. Assessing the situation, Ron Paul wrote in Forbes:

This is nothing less than the creation of another bubble. By attempting to cushion the economy from the worst shocks of the housing bubble’s collapse, the Federal Reserve has ensured that the ultimate correction of its flawed economic policies will be more severe than it otherwise would have been.

The government’s approach could not be more misguided: It seeks to cure the problem of years of excessively low interest rates with even lower interest rates. It is as if a doctor offered an addict more drug when he experiences the inevitable symptoms of withdrawal. The new fix will make the patient feel better for a while, but the temporary surge will only make his eventual crash all the more excruciating. At the G-20 summit the central bankers assured the patient that the drugs will keep flowing. Following their meeting, the markets rose sharply as the junkies took their fix.

Roubini warns of the danger of this in his Financial Times piece: “The Fed and other policy makers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”

Roubini should know of which he speaks. Known also as Dr. Doom, he was one of the few who correctly predicted the housing bust.


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