I always like a story that points out how supposedly wise government employees manage to destroy the very thing they’re trying to protect. Today, the Wall Street Journal fingered the Federal Reserve for much of the turmoil of the last year.
But the larger story is that the global economy is fast popping its latest monetary bubble, the one over the last 14 months in commodity prices and non-dollar currencies.
The original bubble was in housing prices and mortgage-related assets, which the Federal Reserve helped to create with its negative real interest rates from 2002 into 2005. This was Alan Greenspan’s tragic mistake, not that the former Fed chief will acknowledge it.
As for the second bubble, this one began in August 2007 with the onset of the credit panic. This is Ben Bernanke’s creation. The Fed chose to confront the credit crunch as if it were mainly a problem of too little liquidity, not fear of insolvency. To that end it flooded the economy with money, while taking short-term interest rates down to 2% from 5.25% in seven months. The panic only got worse, and this September’s stampede finally led the Treasury and Fed to address the solvency problem by supplying public capital and numerous guarantees to the financial system.
The Fed’s liquidity burst nonetheless sent markets for a 14-month loop, as the nearby charts indicate. The Fed created a commodity bubble of record proportions, with oil doing a round trip in a single year from $70 up to $147 and back down to $69 yesterday. The dollar also plunged along the way against most global currencies, notably the euro, as the bottom chart illustrates.
The dollar price of oil and the dollar-euro exchange rate are probably the two most important prices in the world. They represent a huge share of global commerce, sending signals that shape trade and capital flows. When those two prices move up and down so sharply in so short a time — based more on fear and expectations than on economic realities — they distort price signals and can lead to a misallocation of resources. Commodity prices have now fallen back to Earth, as the reality of global recession hits home and the Fed can’t ease much further. Meanwhile, the euro has fallen from the stratosphere as Europe heads into recession and the dollar becomes a safer haven in a world of fear.