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.