Wednesday, December 2, 2009

Blowing Bubbles and Economic Amnesia

The institutional memory of financial institutions is appalling. And now that there is no downside to risk, we can look forward to perpetual creative destruction.

Investors plowed money into Dubai even though it had no oil. In essence, it had no collateral except the implicit backing of Abu Dhabi, the capital of United Arab Emirates. Abu Dhabi has been deafening in its silence.

Dubai is a hot desert state that built an indoor ski run and islands within its borders. Investors included Citigroup AFTER it received TARP bailout money:

[I]t lent $8 billion to Dubai last year: Oh, and here's an interesting fact: Citigroup made the loan to Dubai on December 14, 2008. Take a look at the calendar--that's after it received tens of bilions in TARP funds.

But Dubai is not the only overextended government. Every country pumping liquidity into its institutions is on the hook. Which includes the United States :

In the United States, for example, Treasury debt maturing within one year has risen from around 33 percent of total debt two years ago to around 44 percent this summer, while falling slightly since then, according to Wrightson ICAP. The United States will soon have debt problems of its own.

Now we turn to bubbles. Or rather, return to bubbles. What happens when money doesn't cost anything? Investors borrow cheap money (dollars) to buy more profitable assets. When everyone piles into the same assets (mortgage-backed securities, for instance) the assets become way overvalued (homes). Right now the Fed is keeping interest rates at near zero. So what's happening?

Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.

Ben Bernarke in his 1999 Princeton professor days argued that the Fed should get out of the way of bubbles because 1) it wasn't possible to determine when they occurred and 2) if the Fed intervened it would cause more problems. Obviously keeping out of the housing bubble was a serious error. Some think incremental interest rate increases would have dampened the credit ardor. As for the bubble's enigmatic invisibility, William Dudley, who is now president of the New York Fed, says that's nonsense:

"I can identify at least five bubbles that one could reasonably have identified in real time," including the tech boom, Mr. Dudley said in a 2006 speech. He knew, he said, because he had speculated against three of them himself when he was chief economist at Goldman Sachs.

Of course, some hold to the view that raising rates is like using a sledgehammer to drive a tack. Says Donald Kohn, the Fed's vice chairman:

"You raise interest rates [to fight a bubble] and you damp all kinds of capital spending and consumer durable spending."

The Fed has been buying Treasury bills and mortgage-backed securities and every other type of depreciated or worthless asset for over a year now. Bernarke is at zero. But no one or no company can get cheap credit except for those deemed too big to fail. There AIN'T no capital spending. How can you dampen nothing?

We can see the bubble. It's here. So what to do?

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