A Tale Of Two Bubbles

Today’s Wall Street Journal notes that the world’s financial problems go well beyond a credit crisis:

The original bubble was in housing prices and mortgage-related assets, which the Federal Reserve helped to create with its negative real interest rates from 2002 into 2005. This was Alan Greenspan’s tragic mistake, not that the former Fed chief will acknowledge it. Testifying before Congress yesterday, Mr. Greenspan pinned the crisis on mortgage securitizers, risk modelers and lending institutions, thus contributing to the Washington narrative that government had little to do with it. The Fed’s monetary policy apparently gets a pass. The media and Members of Congress will use Mr. Greenspan’s testimony to impugn the very free market principles that the former Ayn Rand protégé has spent his life promoting. It was a painful spectacle to watch.

As for the second bubble, this one began in August 2007 with the onset of the credit panic. This is Ben Bernanke’s creation. The Fed chose to confront the credit crunch as if it were mainly a problem of too little liquidity, not fear of insolvency. To that end it flooded the economy with money, while taking short-term interest rates down to 2% from 5.25% in seven months. The panic only got worse, and this September’s stampede finally led the Treasury and Fed to address the solvency problem by supplying public capital and numerous guarantees to the financial system.

But, in the process, the Federal Reserve had created a monetary/commodity price bubble that is clearly reflected in these two charts:


As the Journal points out, the consequence of this monetary bubble is that it has left us, and the rest of the world in a much weaker position to respond to the credit crisis that, even today, continues to rampage it’s way through the financial system. And yet, both major political parties, and both major-party candidates, continue to ignore reality, as the Journal points out:

As Congress plumbs the causes of our current mess, the main one is hiding in plain sight: Reckless monetary policy that did so much to create the credit mania and then compounded the felony with a commodity bubble and run on the dollar whose damage is now becoming apparent. The American people intuitively understand what’s been done to them, which is why they are so angry. If the next President ignores the monetary roots of our troubles, he is courting the same fate as George W. Bush.

Monetary policy isn’t fun, it isn’t sexy, it doesn’t make for cute soundbites or 30 second television commercials, but it’s important and it’s been ignored for far too long. Unless we start paying attention to it soon, the Bush years may start looking like the good old days.

  • tkc

    The decline in commodity prices is also linked to a recession. Less economic output in an industrialized economy requires less energy. Less demand equals lower prices.

    It looked to me that the run into the commodities market was a retreat from the dollar. Once the credit crunch spread to Europe, that put an end to that.

    Either way, it points to a recession.

  • http://pith-n-vinegar.blogspot.com/ Quincy

    tkc –

    I think what you’re witnessing is more a monetary phenomenon than an actual recession. The unwillingness to lend money on the part of many banks causes a crunch that decreases the amount of money available to the economy, sending it into a deflationary mode.

    I would argue that this is necessary for the long-term health of the US economy. The asset bubble was causing overvaluation all over the economy that caused Americans to be ever more dependent on credit for major purchases. It was a vicious positive feedback loop that was finally broken by the global margin call you saw a few weeks back.

    When the economy hits bottom, we’ll have a stronger, more stable dollar and more goods and services available to Americans without credit.

  • http://www.orderhotlunch.com Jeff Molby

    When the economy hits bottom, we’ll have a stronger, more stable dollar and more goods and services available to Americans without credit.

    Uncoincidentally, we’ll also be right back to where we’d be if we had simply been operating under a sound economy with a sound currency all this time.

    The Fed’s engineering seems to do little more than accentuate the extremes our economy vibrates.

  • http://pith-n-vinegar.blogspot.com/ Quincy

    The Fed’s engineering seems to do little more than accentuate the extremes our economy vibrates.

    In so many words… exactly.

  • TerryP

    Actually what I see coming out of this is another inflationary boom in something fueled by all the money that the fed is pumping into our economy now. I am not really sure what it will be, possibly it will be generally everything, maybe it will be RE, most likely it will be commodities, maybe it will be something else but we will likely just go through this whole process again.

    The biggest problem will be that most everyone will be relatively worse off as the dollar we have today will be worth far less in the future. And one of these days because of this the world will decide to either not lend to us anymore or drop the dollar as the world’s reserve currency or both. I think we are already seeing a little of this now. If either of these happens we are in for a world of hurt that makes today’s financial problems look like small potatoes. Though this may be the only way we can get back to some saneness in our monetary policy and force us to become more financially responsibile.