The Federal Reserve is still going through its "lessons-learned" exercise from the financial crisis, but one lesson has not yet been absorbed — the one about ignoring and enabling credit bubbles.
That's the only conclusion to be drawn from the Fed's decision last week to not only keep its benchmark interest rates at zero but also let everyone know that it intends to leave them there for a long time. In case anyone missed the message, Fed officials and other central bankers and finance ministers repeated their promise several days later at a meeting in St. Andrews, Scotland.
Not surprisingly, this sparked a weeklong party in financial markets that already had powerful rallies over the past six months.
"The markets are on a sugar high," Mohamed El-Erian, chief executive of Pimco, the giant money manager, told Newsweek.
Judging from how sharply and quickly these prices have risen, it's a good bet that it is the handiwork of short-term speculation by banks, hedge funds, private-equity funds and other financial center wiseguys moving as a herd, financing their purchases with some of that yummy, zero-percent Fed money.
For many investors, the cost of money is effectively less than zero, as economist Nouriel Roubini likes to point out. If you borrow dollars at near zero percent interest in the United States, exchange the dollars for Thai bhat and invest the bhat in government bonds paying 4 or 5 percent, you not only get the benefit of the interest rate arbitrage but you also gain when you sell the bond and exchange the bhat back into dollars that have since depreciated. Roubini calls it "the mother of all carry trades," and in recent months he calculates that it has been generating annualized returns for investors of 50 to 70 percent.
This carry trade is now so widespread that it has become a major factor driving down the value of the dollar against many other currencies and driving up the flow of hot money into a number of developing countries. Not only has it spawned stock, bond or real estate bubbles in those countries, but it's also driven up the value of their currencies to the point that their exports are less competitive relative to countries, including China, that peg their currencies to the dollar.
There's no way to know how long all this can continue before one of these bubbles finally bursts, the dollar spikes upward and investors all rush to unwind their trades at the same time. But it is a good guess that it will last as long as the Fed and other central banks indicate there is no end in sight for the current cheap-money regime. The longer they wait, the bigger the bubbles, and the bigger the mess to clean up.
All of which is why the recent statements by policymakers were so disappointing — and so dangerous. The policy might make some sense if all this credit was flowing to worthy households and businesses. The evidence, however, suggests that much of it is going toward short-term financial speculation that is great for boosting bank profits and fattening the bonuses of Wall Street wiseguys — but lousy at producing sustainable long-term growth.