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Stock Market Bubble Created by Fed Policies

Posted by Steve Markowitz on July 31, 2014

The 2008 meltdown was largely created by Federal Reserve policies. Since the latter part of the 1990s, previous Fed Chairman Alan Greenspan turned on the spigot of easy money any time there was even minor economic downturns. Historically low interest rates were the favorite tool

The Fed policies damaged the moral hazard leading to irrational investment behavior, as well as poor business judgment especially by banks and other lending institutions. It also led to unsustainable increases in the housing values that created the mother of all bubbles. Not to miss a turn at the punch bowl, governments overspent due to increased tax revenues from the bubble economy.

The Fed doubled down on its easy money policies in response to the 2008 financial meltdown. The consequences are yet to fully play out, but have the potential to be huge.

In a nutshell, the 2008 financial meltdown was caused by excessive debt in the private sector. Through bank bailouts and other governmental interventions, a significant portion of the debt was moved to the public sector; i.e. sovereign debt. With central banks printing money and purchasing the debt, countries including the United States have been able to borrow money at artificially low interest rates creating the illusion of wealth.

There will be a cost and a day of reckoning for the reckless Fed policies. We saw a glimpse of a consequence today when the Dow Jones Industrial Average dropped more than 300 points, nearly 2%. Today’s drop was mainly the result of Argentina defaulting on its debt. Other countries face similar challenges.

Should the world’s financial markets continue to exhibit nervousness, it is predictable as to the Fed’s reaction. They will once again flood the market with more liquidity through quantitative easing. Governments will also have an excuse to expand their deficits with more spending.  This story has been told throughout history and it is never ended well.

Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, wrote an op-ed for the Wall Street Journal, Liberals Love the ‘One Percent’, that reviews some of the problems with the Federal Reserve’s policies:

  • While Fed Chairperson Janet Yellen indicated that its policies are designed “to help Main Street not Wall Street,” it has done the opposite. While the current recovery has been the slowest since World War II averaging only 2% annually for the past five years, this has been the most powerful stock market recovery during that same period increasing by 135%. A substantial portion of equity assets are owned by wealthier Americans, which has increased the wealth disparity in the United States.
  • The easy money Fed policies has fed an industry that creates financial instruments to make money on commodity trading and price variations. The best and brightest have learned that there is more money to be made in financial manipulation than inventing and building products.
  • Commodity prices have significantly increased since 2009. On average the increase is 40%, double the rate seen in commodity price increases in recoveries since World War II. In addition, price increases on staples such as food are significantly more problematic for the poor and poor countries, again increasing income disparity.
  • It is likely some commodities are in bubble territory. When they pop, while this will offer relief for those dependent on commodities for subsistence, it will likely lead to financial stress on the financial sector that will lead to a call for more bailouts.
  • Borrowing is often used to finance capital equipment purchases. The current artificially low borrowing costs offer incentives to companies to invest in capital equipment for efficiencies, rather than hire more labor, further depressing the employment.
  • Even some companies flush with cash are barring at the artificially low corporate bond rates and using the funds for less than productive purposes, such as mergers and acquisitions.

As Sharma insightfully concludes, “the Fed can print as much money as it wants, but it can’t control where it goes much of it is finding its way into financial assets”.  Central bankers throughout modern history have proven inept when it comes to proactive policies designed to fix economic distress.  Chairman Greenspan didn’t even see the housing bubble when had already actually popped.  Expecting them to have it right this time is little better than wishful thinking.

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