Easy Money and the Decapitalization of America

February 9, 2011

Since past expansionary monetary policies led to bubbles, we should expect that even more expansionary policies pursued since the onset of the current financial crisis to produce new bubbles.  This is exactly what Kevin Dowd, an adjunct scholar at the Cato Institute, and Martin Hutchinson, a former banker, find.

  • Within the United States there are at least three very obvious bubbles currently in full swing, each fuelled by the flood of cheap money: Treasury bonds, financial stocks and junk bonds.
  • Dowd and Hutchinson are confident that these bubbles will come to unpleasant ends like their predecessors, but on a potentially much grander scale.

There is also the problem of resurgent inflation.  For a long time, the United States has been protected from much of the inflationary impact of Federal Reserve policies: developments in IT and the cost reductions attendant on the outsourcing of production to East Asia had the impact of suppressing prices and masking the domestic impact of Fed policies.  Instead, these policies have produced a massive buildup in global currency reserves.

  • U.S. inflation was already rising by 2008 (annual rate 3.85 percent), but this rise was put into reverse when bank lending and consumer spending then fell sharply.
  • However, the huge additional monetary overhang created over the last couple of years must eventually flood forth -- and, when it does, inflation is likely to rise sharply.
  • Once inflation makes a comeback, a point will eventually come when the Fed policy has to go into sharp reverse.

The consequences would be most unpleasant:  the United States would experience the renewed miseries of stagflation.  Moreover, as in the early 1980s, higher interest rates would lead to major falls in asset prices and inflict further losses on financial institutions, wiping out their capital bases in the process.  Thus, renewed inflation and higher interest rates would deliver yet another blow to an already gravely weakened financial system, according to Dowd and Martin.

Source: Kevin Dowd and Martin Hutchinson, "Easy Money and the Decapitalization of America," Cato Institute, January/February 2011.

For text:

http://www.cato.org/pubs/policy_report/v33n1/cpr33n1-1.html

 

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