The wreckage of the housing bubble and the banking crisis haven’t yet been cleared away completely, but already there are hints of renewed speculation – warning signs of a problem that often arises when central banks try to bolster weak economies.
Expanding the amount of money in circulation is, of course, beneficial in the short run because it stimulates business activity and takes some of the pressure off overextended borrowers and banks. But easy money also encourages risk-taking and temporarily pushes the prices of safe investments up to unsustainable levels, thereby creating the potential for future financial crises.
This problem last occurred – with catastrophic results – in the years following the 2000 technology stock crash, when Federal Reserve Chairman Alan Greenspan repeatedly stoked the money supply. That did help revive the U.S. economy, but it also fueled a bubble in home prices that contributed greatly to the 2008 banking crisis. Moreover, Fed officials seemingly failed to recognize this side effect as it was happening. Around the time the housing bubble peaked in 2006, Fed Vice Chairman Timothy Geithner (now the Secretary of the Treasury) summed up the official outlook: “This, on balance, still leaves us with what looks like a relatively balanced set of risks around what is still a quite favorable growth forecast.” In retrospect, that assessment was much too blithe. Indeed, in testimony before Congress in October 2008, Greenspan himself acknowledged that he had underestimated the risks of his policies.
Is current Fed Chairman Ben Bernanke making the same mistake – risking future bubbles because he is trying to compensate for a past one? Obviously, it’s too soon to tell. But Bernanke has already gone further than previous Fed officials in one respect, at least. Traditionally, Fed Chairmen have refused to tip their hand. Alan Greenspan once famously remarked: “Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” Bernanke, by contrast, has bluntly announced that he will hold down interest rates close to zero until 2014. That may be intended as a confidence-building measure, but it will also make speculators feel more secure. Consider these signs of a growing appetite for risk:
Aggressive investments are becoming more popular. Low interest rates are making investors take greater risks in the search for yield. Sales of junk bonds picked up in January, and February looks strong as well, with billion-dollar-plus offerings by casino owner Caesars Entertainment and hospital operator HCA. Insiders at tech companies are also finally seeing a chance to cash out after four years in which a bad stock market discouraged initial public offerings. IPO activity at the start of 2012 was the greatest in seven years, and will likely pick up further if Facebook’s enormous offering goes off well. This IPO would value Facebook at as much as $100 billion, or more than three times as much as Google’s 2004 IPO, which took place just as the housing bubble really got going.
Safe investments have enjoyed big price gains recently. The Dow has climbed 20% since October on economic statistics that are only mildly encouraging. Moreover, the Congressional Budget Office projects that the economy will slow later this year. In my view, the explanation for share-price gains that are stronger than the economic outlook justifies is that hot money fleeing Europe is looking for safe havens – one of which is the U.S. stock market.
Today’s biggest bubble in safe assets, however, is the one in Treasury bonds, which is a direct consequence of the Fed’s policy of holding interest rates down at abnormally low levels. Bond prices move in the opposite direction of interest rates, so when the Fed holds rates down, it is propping prices up. And when the Fed eventually does allow rates to rise to more normal levels – even if that really isn’t until 2014 – bond prices will fall significantly.
European banking policies are also encouraging risk-taking. Similar to the Fed’s attempts to reflate the U.S. economy, the European Central Bank has made hundreds of billions of euros available to European banks on extraordinarily generous terms. The institutions are not only using the money to meet their own short-term financing needs, they are also borrowing additional money to purchase the bonds of troubled countries and earn the spread between the yields on those bonds and the much lower rate the ECB is charging them for money. This strategy is known as the carry trade, which I discussed in a recent column. By trying to make a little extra money, European banks are increasing their exposure to Eurozone problems. If the Eurozone crisis gets worse, the entire global banking system will feel the effects, including institutions in the U.S.
None of these bellwethers – either individually or taken together – means that there will be another financial crisis in the next few months – or even the next few years. Perhaps everyone will back off a bit and calm down after the November elections. But current trends are consistent with the warning economists always give about moral hazard – the idea that no-fault bailouts and easy money encourage future reckless behavior. At the very least, the proper response for investors is greater prudence and caution.