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The Federal Reserve is inflating another bubble

By Thomas E. Brewton
web posted January 25, 2010

In the last two trading days of the week ending January 23rd, the Dow Industrial Index plummeted 430.170 points, the worst decline in a year.  Major factors, according to Street gossip, were continuing weakness in corporate sales and growing fears that Helicopter Ben Bernanke might not be re-appointed Fed chairman.

As the Wall Street Journal reported:

Much of the selling Friday, which took the Dow down 2.1% to 10172.98, was pinned on news out of Washington, where more Democratic senators came out against the nomination of Ben Bernanke to a second term as Federal Reserve chairman.

"It felt as though every time a senator came out expressing doubt or uncertainty about their willingness to vote in favor of Bernanke, it took us down another five points," said Craig Peckham, equity trading strategist at Jefferies & Co.

Why would the possible loss of Mr. Bernanke at the Fed cause a stock market panic? 

The answer is that money managers and individual investors have come to rely upon the Fed's readiness to pump up the stock market with increases in the money supply that lower interest rates. 

Much of the stock market's spectacular 61% rise from the March, 2009, low point to the high point on January 19, 2010, was the product of unprecedented loose money and low interest rates, and of Mr. Bernanke's continual assurances that he would keep it that way.  At the beginning of the past year, stock market columnists noted that vast amounts of investment funds were on the sidelines.  Despite murky economic conditions, money managers piled back into the higher-risk stock market in the expectation of continuing Fed accommodation.

Money managers and stock traders had reason for that expectation.

From 2001 to 2004, the Fed pumped massive amounts of fiat money into the economy to deal with the collapse of the dot.com bubble that cratered the stock market.  Before that the dot.com bubble had been inflated by the Fed's bailout of Long Term Capital Management (LTCM) in 1998.  LTCM itself was a bubble enabled by the Fed's flooding the markets with money after the 1987 stock market crash.

In the short run, which is the only dimension on the radar screen of liberal-progressivism's Keynesian economics, stock markets tend initially to rise under those conditions.  Usually within a year or two, however, inflation takes hold and punishes the stock market.  Other financial market assets are similarly affected, as happened most recently in the housing bubble and collapse of the subprime, securitized mortgages.

Mr. Bernanke's short-sighted policies at the Fed produce both low interest rate on Treasuries and declining purchasing power of the dollar.  Creating vast amounts of money out of thin air lowers interest rates until inflation takes hold.  It also reduces interest rates until business begins to expand.  In the long run, consequent inflation causes investors to demand much higher interest rates to compensate for the dollar's loss of purchasing power.  Those higher interest rates choke business expansion, reduce government's tax revenues, and lead to demands for newer and larger deficit spending programs that set the stage for yet another round of recession and inflation.

Last year there were two short-term factors in play.  First, the lowest-risk place to park investable funds was in short-term U.S. Treasury securities. But short-term Treasuries were, and still are, yielding far less than 1% per annum, much less than the rate at which the purchasing power of the dollar is declining.  The Fed's loose-money, low-interest-rate policy, and Mr. Bernanke's assurances that interest rates will not be increased rapidly or soon, gave money managers strong incentive to put investable funds into higher-risk securities.  Ergo, the booming stock market.

Second, Mr. Bernanke and his predecessor Alan Greenspan steadily held to the Keynesian economic faith that unlimited amounts of fiat money will cure any economic problem.  Because the stock market had come to expect that policy, money managers, as noted, felt fairly safe in jumping back into the stock market, believing that all that Fed-created money supply had nowhere else to go.

Meanwhile, the real economy is marking time.  Corporate earnings have bounced back somewhat, almost entirely as a consequence of cost-cutting and higher productivity per worker.  That's another way of saying that business remains very cautious about the unknowable extent to which the socialist Obama administration will hammer them with higher taxes and higher medical benefits costs, as well as what further nationalizations or draconian regulations may be imposed to punish business.  Businessmen will defer significant re-hiring of employees until they know the full extent of the socialistic depredations to be inflicted by the Democrat/Socialist Party. 

If President Obama continues publicly to berate bankers and businessmen and Congress continues to impose costly new liberal-progressive programs, business will remain slow to ramp up production, and unemployment will remain high.  Without growth of sales to raise business profits, the stock market will enter another cycle of decline. ESR

Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets. His weblog is The View from 1776Z. Email comments to viewfrom1776@thomasbrewton.com.


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