Why Future Asset Bubbles Can Be Expected

by: John M. Mason

We have been told for at least two years now that the problems in the banking sector are liquidity problems. But liquidity problems are of short-term nature and need to be resolved within a relatively short period of time.

The policies that are used to combat a liquidity crisis are also of a short-term nature. These policies are based upon the need to supply the market with liquidity so that asset prices will stop dropping. Given this interpretation, the Federal Reserve, under Chairman Bernanke’s leadership, has supplied liquidity ... and more liquidity ... and more liquidity to resolve the issue.

This is a sign that the model being used by Bubble Ben and the Fed is inappropriate for the particular situation that they face.
But this was the policy prescription for the Federal Reserve in the early 2000s when interest rates were kept around one percent for about 18 months. And, what did we get? A pair of asset bubbles.

In terms of fiscal policy, the situation is similar. The “experts” in the Obama administration, led by Treasury Secretary Tim Geithner, have called for more spending
... and more spending ... and more spending.

In both cases, the reason given why the policy prescription is not working is that the particular stimulus package tried has not been large enough. The solution Ben and Tim have given is to make the policy package larger. More spending
... and more liquidity.

This is a sign that something is wrong. The model and the analysis being used are not appropriate. The model being used to develop economic policy must be changed.

In the financial markets, the problems that exist are solvency problems. Households are declaring bankruptcy in record numbers and foreclosures on homes continue to run at very high rates. Small businesses are also declaring bankruptcy and loan demand coming from small businesses is dropping as of the last Federal Reserve survey. Thousands of small banks are on the verge of insolvency. (See
It's a Solvency Problem, Not a Liquidity Problem).

And guess what? The monetary policy that the Federal Reserve is following has successfully resulted in the accumulation of massive amounts of cash in the hands of large banks and large corporations. I am just waiting for the acquisition binge to begin once the economy stabilizes a little more. So much for "Main Street."

In the economy, the “consensus” economic model that has been used over the past fifty years is still contributing to the “more-of-the-same” policies that are being followed by the Federal Reserve and the Treasury Department
Yet over these past fifty years the application of this model has produced the following results: the United States has moved from an “under”-employment rate of around 8% of the working population to about 25% in the current environment; these policies have also resulted in the capacity utilization in industry moving from about 93% in the 1960s to about 75% at the present time, constantly eroding throughout the whole time period; and the distribution of income in the United States over this fifty years has moved dramatically toward the most wealth end of the spectrum.

The foreign exchange markets have signaled to the United States that something is wrong. Over the past fifty years, the value of the dollar has declined by more than 40% in foreign exchange markets. After a recovery in the latter part of the 1990s, the value of the dollar once again tanked until we hit the financial crisis of 2008 and there was a “stampede to quality.” Once this “stampede” was over and markets and economies stabilized, the value of the dollar declined once again. And, after Ben made his remarks in Jackson Hole concerning the forthcoming quantitative easing, the value of the dollar plunged 7% in a matter of weeks.

Paul Volcker has written that the most important price in a country is the price of its currency in terms of other currencies. If the value of your currency declines, this is a sign of weakness: weakness in your economy and in your economic policies.

So here we are. Thursday November 11, 2010, the President of the United States was lectured to by Hu Jintao, the Chinese President, over the United States currency. Other world leaders, from Germany, Great Britain, and Brazil, have also reprimanded the President over the United States currency situation. Furthermore, given the election results in the mid-term elections held last week, the American people seem to have a problem with United States economic policies.

The policy direction in Washington needs to be changed and changed soon. However, I don’t expect a change to be made in the near future. President Obama seems to be adamant that this policy must be effectively enforced. Therefore, as in the early 2000s I expect bubbles to occur here and there.

The problem is, as we well know, sooner or later, bubbles burst.