Easy Money Did Us In - Geithner

by: Rolfe Winkler, CFA

In an interview with Charlie Rose on Tuesday, Tim Geithner admitted the bubble was caused by Greenspan’s easy money policy. Unfortunately, Charlie didn’t ask the obvious follow-up: “Why will this time be different? Why will Bernanke’s easy money policy lead to different results?” Here was the crucial exchange:

Rose: “Looking back, what are the mistakes and what should you have done more of? Where were your instincts right, but you didn’t go far enough?”

Geithner: “…I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful.”

Rose: “It was too easy.”

Geithner: “It was too easy, yes….

What makes Geithner’s admission so frustrating is that the government is engaged in the same disastrous policy today, to fight the same bogeyman: deflation.

As Geithner makes plain, a huge side effect was that investors seeking meaningful returns inflated the bubble taking flyers on overpriced, risky securities. Toxic structured products are the obvious example. Credit rating agencies get lots of blame as enablers, rating trash “AAA.” But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields; hell, artificially low interest rates meant many needed an excuse.*

Truly low risk securities like Treasurys and money market instruments were yielding so little, they were of no use to portfolio managers trying to match assets with liabilities. That’s a simple concept, really. Pension fund managers, for instance, rely on actuarial estimates to determine their future liabilities. What the plan will have to pay out to retirees at a particular future date. So they have to invest in such a way that plan assets will grow to meet plan liabilities. Stocks are typically too risky, so they rely on high quality “AAA” fixed-income securities that offer modest rates of return while guaranteeing principal.

But what happens when low-risk fixed-income securities yield 0% or close to that? Asset managers are more or less forced to seek higher interest rates through riskier investments.

So what are the results of our latest experiment with rock-bottom rates? Investors are piling back into risky investments across the board. Taking just one example, FT noted this week that high-yield debt is skyrocketing. The “experts” cited in the article claim this is proof that we’ve come through the worst of the recession. In their brains, markets still operate efficiently, so the running bulls must reflect improving fundamentals.

First of all, efficient market theory doesn’t apply to asset markets the way it applies to goods markets. But even if it did, how can folks pretend that a market with fixed prices (i.e. the Fed’s stranglehold on interest rates via open market ops) is clearing efficiently?

Geithner admits that the “overwhelmingly powerful” force of low rates inflated the bubble. So how can he/Bernanke justify the same approach this time ’round? No doubt they’d argue they’ve no other choice: a ponzi system “relying on credit” needs credit to flow or else it will collapse. It doesn’t occur to these guys that the system itself is flawed, that we need a gut renovation, not just another layer of paint.

No doubt de-leveraging would be quite violent if the Fed left rates higher. But de-leveraging is the only solution to the crisis. God forbid Bernanke’s easy money policy actually “works;” God forbid he “rescues” the economy by reflating the credit bubble. De-leveraging is coming, whether we want it to or not. Better we rip the band-aid off quickly…


*Not that CRAs are blameless. They deserve every ounce of criticism they’ve received.