Easy money causes bubble; easy money cures bust

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Haven't we seen this movie before?

Central bank runs easy monetary policy.

Easy money inflates asset bubble. Central bank tightens monetary policy.

Asset bubble bursts.

Central bank runs easy monetary policy to offset effects of burst bubble. Easy money inflates bubble.

This movie played in first-run houses and in rerun during Alan Greenspan's 18-year tenure as Federal Reserve chairman.

In the late 1990s, it was technology and Internet stocks that went to the moon. Companies with no income, no assets to speak of, even no viable business, were trading at sky-high prices relative to non-existent, not-expected earnings.

That party ended in 2000. Down went the stock market. The Nasdaq Composite Index fell 78 percent from its March 2000 peak to October 2002 trough.

Down went business investment.

Down went the Fed's benchmark overnight rate to a low of 1 percent in June 2003, where it remained for a full year even as the economy was taking off. The gap between the Fed funds rate and nominal gross domestic product one shorthand way to assess the stance of policy reached a three-decade high of 5.9 percent.

A house divided

Not everything was going down.

Thanks to ultra-low interest rates and the proliferation of adjustable-rate mortgages with all kinds of options (including not paying), housing took off.

People with no income, no assets and no viable job were buying homes.

In short order, a house went from a stable residence to something to flip for a quick profit.

Derivatives created from these ne'erdo-well mortgages didn't just transfer risk from those who didn't want it to those who could bear it (a favorite Greenspan maxim); they spread it far and wide. A hedge for one investor is a speculative instrument for another.

That party ended, too with a crash. With global stock markets practically in freefall, central banks of the world united Wednesday, announcing coordinated interest-rate cuts at 7 a.m. New York time.

The Fed, the European Central Bank (which had resisted calls to come to the aid of weakening economies in the face of stubbornly high inflation), the Bank of England, the Bank of Canada, the Swiss National Bank and Sweden's Riksbank all cut their benchmark rates by 50 basis points.

The Bank of Japan "expresses its strong support of these policy actions," according to the Fed statement, but it took a pass on adjusting its 0.5 percent benchmark rate.

Boom-bust business

One day earlier, the Fed announced the creation of a new facility to buy commercial paper.

The Fed's overnight rate, now 1.5 percent, is the lowest of the bunch. With the boom-bust business now a decade old, it seems appropriate to ask the question:

If easy money was the source of the (fill in the blank) bubble, how can easy money be the cure?

Haven't we heard that question before? Yes, I posed it in a 2002 column. And six years later, I'm still looking for the answer.

It's not that a 1.5 percent funds rate is inappropriate to the current financial and economic crisis.

I would have said the same thing about the 2 percent funds rate before Wednesday.

If central bankers thought a coordinated cut would have more impact with the Fed than without, then so be it.

Panic upon panic

Taken in conjunction with the almost daily introduction and/or expansion of the Fed's various lending facilities and its exploding balance sheet of questionable collateral one friend calls it a "monetary brothel" Wednesday's action has the feel of a panicked reaction to a panicked market.

That's not what the US economy needs. Treasury Secretary Hank Paulson's $700 billion Troubled Asset Relief Program, as first outlined, was more of a sketchy idea than a fully fleshed out plan for the biggest government intervention in history.

Appointing a 35-year-old Goldman Sachs alum to run his home for troubled assets didn't instill confidence at a time when some folks think Treasury is running a policy of, by and for Goldman.

And community bankers had to tell Hank that insuring higher-yielding money market funds would mean a mass exodus from banks, which is exactly what the government is trying to avoid.

To the extent that each government action causes an equal (and seemingly negative) market reaction, one has to wonder what policy makers will do for an encore.

Unenthusiastic reception

Europe's major stock indexes ended Wednesday with losses of 5 percent or more.

Some credit spreads widened. US stock markets blew hot and cold and ended lower. The Dow Jones Industrial Average fell 191 points, for a loss of 10 percent so far this week.

We may have seen this movie before, but earlier versions the Great Depression notwithstanding were milder, shorter and much less violent. It's hard to predict how or when this one will end.

Having studied the Great Depression, Fed Chief Ben Bernanke knows the risks associated with doing nothing and doing too much.

Having inherited the downside of Greenspan's bubble, he knows the temporary cure of easy money can quickly morph into the next bubble.

Reported by Caroline Baum.

(Caroline Baum is a Bloomberg News columnist. The opinions expressed are her own)

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