From the October 2007 issue of Research Magazine • Subscribe!

Success or Excess?

In mid-August, international financial markets began seriously to wobble. Initially, the subprime mortgage crisis, affecting only a small, risky portion of the enormous U.S. residential mortgage market, was thought to be a minor chip in an otherwise bright economic picture in the United States and around the world. Subprime mortgages measure slightly more than 10 percent of the $7.8 trillion in outstanding U.S. mortgage debt.

But it quickly turned out that complex derivatives based on high-yielding mortgages, such as collaterized debt obligations, were held in funds run by important players, such as Bear Stearns. Concern spread about more mainstream U.S. mortgages and other forms of consumer debt. Suddenly, banks reversed their happy-go-lucky lending policies and a global credit crunch began to loom.

In mid-August, when all these fears started to gel and stock prices tumbled, the U.S. Federal Reserve initiated large-scale liquidity infusions into the financial system. Other major central banks around the world joined in, with the European Central Bank contributing a massive $130 billion in extra liquidity.

By early September, when selling continued, the Bank of England abandoned its previous hands-off, laissez-faire stance and stepped in to reduce rocketing domestic lending rates.

Financial markets are rooting for the Fed and other world central banks to succeed, of course. Fed chairman Ben Bernanke had said previously that the Fed should dump money out of helicopters if it needed to prevent financial panics.

Determined central bank intervention is likely to allay investors' fears sooner or later. The question is whether it is going to be a good thing.

Moral HazardThe most important objection to central banks bailing out overstretched investors is known as moral hazard. The argument, explored by 19th century British economist Walter Bagehot, is that bailing out foolhardy investors will encourage them to behave even more recklessly next time, creating worse bubbles going forward.

In fact, even without an organized central bank bailout, recent financial market scares, instead of sobering up overstretched investors, have had the effect of spurring renewed buying frenzies. Thus, the selling in May-July 2006 encouraged a record-breaking rally that lasted through February 2007. On Wall Street, the Dow Jones industrial average broke through 12,500 during that period.

Then, in late February and early March, a China-inspired panic was followed by another run-up in world stock market indices, this one lasting until mid-July. The Dow pushed above 14,000. The index of the world's most solid -- and supposedly stolid -- U.S. companies thus gained around 40 percent in slightly over two years.

Broad international stock indices compiled by Morgan Stanley Capital International have had an unprecedented run during the current market rally dating back to 2003. By mid-2007, the MSCI emerging market index tripled in value in U.S. dollar terms, while the developed market index "merely" doubled.

Symptoms of an ImbalanceBut overbought stock markets are only one of several problems festering in the global financial system. Bond markets around the world have been similarly distorted. In most government bond markets, yield curves have been flat or inverted for several years -- an unusually extended period -- giving investors incentive to keep money in cash, money markets or highly liquid short maturities, rather than investing into riskier long bonds. In other words, the liquidity penalty -- and reward to long-term investors -- has effectively disappeared.

Instead of investing in long maturities, investors looking for a yield pick-up reached further out along the risk curve, bidding up prices of risky debt and depressing yields. Spreads on Eurobond issues by emerging borrowers narrowed to record lows. The EMBI+ index tracking spreads over U.S. Treasuries fell to a record low around 1.5 percentage points earlier this year. Just two years ago, the spread measured around 300bps, also a record at the time.

Finally, distortions impacted foreign exchange markets as well. The Japanese yen, the currency of one of the world's most efficient exporters and a top supplier of capital, has been driven extremely low. The U.S. dollar, the global reserve currency, lost 40 percent of its value against the euro since peaking in October 2000 and traded at its lowest level in over a quarter of a century against the U.K. pound, the Canadian dollar and a bunch of other currencies. The greenback's real trade-weighted exchange rate bottomed at around 75 percent of its 1973 level in mid-2007.

Liquidity TrapHowever, these financial market imbalances are merely symptoms. The true culprit is excess liquidity.

In the early 2000s, when the Internet bubble on Wall Street deflated quickly after the Nasdaq Composite index surpassed 5,000 in March 2000, the Fed began cutting interest rates rapidly. The Fed funds rate, which stood at 6.5 percent at the time, was reduced in response to relentless selling on Wall Street and pushed even lower, to just 1 percent, following the terrorist attacks on September 11, 2001.

Rates were held at very low levels through mid-2004, long after the U.S. economic cycle had turned. The Fed then hiked its rates for two years, stopping at 5.25 percent in mid-2006. The European Central Bank continues to raise its rates, but they remain at 4 percent. The Bank of Japan keeps its rates at 0.5 percent.

Central banks have been able to raise their rates gradually because of an apparent lack of inflationary pressures. In the United States, the consumer price index averaged only around 2.6 percent over the past seven years. Inflation-adjusted interest rates, measured against headline CPI, have been close to historic averages.

However, official inflation has been skewed by stable -- and even declining -- prices for generic manufactured goods and basic services. Technological advances have boosted efficiency and improved productivity, while also enabling companies to relocate production to remote parts of the world where labor is cheap and environmental and other constraints are negligible.

Paradoxically, plentiful liquidity has had the effect of depressing consumer prices. It has fed an investment boom in China, India, other parts of Asia, Latin America and Eastern Europe, generating more supply and forcing producers to compete on price.

Easy LendingFlush with funds, banks chased after corporate and retail borrowers, relaxing their lending standards. Hence the subprime mortgage crisis and the overleveraging of many top financial players. The worldwide house price bubble -- which impacts not just in the United States, but the U.K., continental Europe, Australia and New Zealand and other parts of the world -- has been the direct result of easy credit and a surfeit of liquidity.

Once more, this was a distortion that fed on itself. Rising house prices went hand in hand with a consumption spree, especially by U.S. consumers who ran up second mortgages and credit card debt secured by the rising equity in their homes. The U.S. saving rate fell into negative territory in 2005 (where it remains), imports have increased steadily and the trade deficit has increased more than sevenfold over the past decade.

The U.S. trade deficit -- resulting in an annual outflow of over $700 billion abroad -- has spread the U.S. liquidity glut to the rest of the world. Central banks in countries running trade surpluses with the United States have had to buy dollars from domestic exporters in order to keep their currencies from spiking against the greenback. This required printing more domestic currency. Excess liquidity has been driving financial market bubbles in key emerging markets, while trillions of useless dollars have accumulated in central bank vaults.

Healthy Cycles Economic cycles have always been an integral part of a free market economy. Much like forest fires, they take care of imbalances that arise during periods of robust growth, wiping the slate clean. Foresters at U.S. National Parks discovered that the hard way. By not letting forests burn periodically, they allowed dead wood to choke up living trees and wound up with severe fires that tended to burn quickly out of control.

Providing more liquidity to the world financial system just adds fuel to financial market distortions and patches up dangerous bubbles. Foolhardy investors need to be punished by the bracing hand of the market to correct the overall system.

Instead, by molly-coddling investors now, the Fed and other central banks signal to financial markets that there will always be a safety net to bail them out. This will only perpetuate and exacerbate market distortions, and encourage investors to take on ever greater risk in the future. In the end, there might come a time when even the Fed won't be able to prop up a financial pyramid.


Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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