Jackson Jambalaya

George Melloan warns in the Wall Street Journal about the asset bubble created by the Fed:

We've learned a lot about asset inflation since that speech, but maybe not enough. The nearly 2,000-point rise in the Dow Jones Industrial Average since last June no doubt at least partly reflects asset inflation, since there has been very little in the economic or political outlook to justify it.

Midwest farmland prices were rising at a 13% annual rate last fall even after a summer of crippling drought. How could drought-stricken farms be gaining value so rapidly, other than through inflation generated by cheap credit? House prices also are climbing again in many areas, much as they were during the asset inflation of the 2000s. Those are the same houses that were on the down escalator not long ago. Call it "asset reflation."

Asset inflation often produces something called "wealth illusion," the belief that pricier asset holdings necessarily make one permanently richer. Illusions are dangerous. Eventually, painful reality intervenes.

We've been down this road before. Mr. Greenspan was cautioning himself as well as Wall Street in his AEI speech when he said, "we should not underestimate, or become complacent about the complexity of interactions of asset markets and the economy." After nearly a decade on the job, he knew the uncertainties of managing a fiat currency. He also knew that tightening the money spigots in boom times required the courage to face the political outrage that invariably results.

Seven years later, Mr. Greenspan would fail to heed his own warning. Urged on by his soon-to-be successor, Ben Bernanke, Mr. Greenspan would hold interest rates down too long, setting off a mid-2000s credit binge that sent assets soaring, home prices in particular. Congress developed a blasé attitude toward huge budget deficits, simply because Fed policy made them easy to finance. State and local governments overleveraged themselves. This was "irrational exuberance" indeed.

When the Fed finally tightened credit, the bubble burst, with a resulting stock-market crash, a vast wave of home foreclosures, public-sector pension funds in distress, and many state and municipal governments technically bankrupt. As Mr. Greenspan had feared, a crash in asset values did profound damage to the real economy. We are still living with it.

At least Chairman Greenspan understood the risks. It is not clear that Chairman Bernanke is aware that he has now set the Fed's asset-inflation machine on automatic pilot by promising near-zero interest rates well out into the future. The longer the policy continues, the greater the difficulty in climbing down from the debt mountain it is creating, particularly the rapidly rising national debt.

President Obama and Mr. Bernanke worsened the effects of the 2008 crash by adopting the same Keynesian antirecession measures—fiscal and monetary "stimulus"—that had failed before, most dramatically in the 1970s. Stanford economist and former Treasury official John Taylor recently argued persuasively on these pages that "stimulus" measures had retarded rather than speeded recovery.

Mr. Bernanke will have great difficulty letting go of the near-zero interest rate policy without severe consequences for both the Fed and the economy. The Fed's own economists recently warned that the Fed itself could lose as much as $100 billion on its vast portfolio when bond prices finally fall from their artificially elevated levels. Meanwhile, higher interest rates will cause the cost of financing government debt to skyrocket.

The Fed policy of quantitative easing is designed to rebuild the asset inflation edifice that collapsed in 2008. German banker and economist Kurt Richebächer provided some of the earliest warnings of the dangers. In his April 2005 newsletter, he wrote that "there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output."

The rising Dow is of course good news for savers, who have been forced into equities to try to find a decent return on investment. Thanks to Fed policy, "safe" 10-year Treasury bonds yield a near-zero or negative return, depending on whether you measure price inflation at the official rate or at higher private estimates.

Winners on stocks or land holdings should happily accept their gains as the best to be expected in a very unsettled financial environment. But they should also remember the 2000s, when so many people thought their newfound riches were real and cashed them in for yet more debt, such as home-equity loans.

They later had a rude awakening. The "wealth illusion" of asset inflation is seductive, which is why central banks in charge of a fiat currency and subject to no external disciplines so often drift in that direction. Politicians smile in satisfaction and powerful Washington lobbies cry for more.

But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long.

Interesting letter to the editor in response to this column:


The next big bubble is growing right before our unseeing eyes: the bubble in Treasury debt. Unlike homes or farms, this "asset" can be produced from thin air by our which auctions it and the Federal Reserve which buys it. The Fed now holds $1.7 trillion in Treasury debt, comprising more than half its assets.  Holders of the other $9.9 trillion in Treasurys have been trained since infancy to consider this paper risk-free and super safe. They do not consider that settlement of these debts can be accomplished in only two ways: future taxes or currency devaluation. As Mr. Melloan alludes, the devaluation route has already been selected, though none dare speak its name.

What event might burst the Treasury bubble? A selloff by a major holder, a sudden spike in inflation, another federal fiscal crisis or an auction failure could trigger a Treasurys panic. The problem is that there's no place to which $9.9 trillion can quickly move. If the demand slackens, holders (including the Fed) will largely be stuck with the declining paper. The Fed could easily lose more than the $100 billion Mr. Melloan cites.

Steven Teeter