New Bubbles in the Economy Could Be Forming with Cheap Money

With interest rates close to their historical lows, some economists believe that new bubbles might be forming in some areas of the economy. If this is true, the Fed could be solving the current crisis but giving rise to a similar problem in future.

The Fed uses changes in interest rates as a way of boosting the economy or controlling inflation. After the financial crisis, as the economy went into a deep recession, the Fed cut interest rates in quick succession. The current Fed rates are close to zero, and if indications from Ben Bernanke are to be believed, rates could stay low for a long time.

However….

Although the economy has improved, there is no reason to believe that the recovery would be sustainable. Unemployment is still high and unless it starts falling drastically, there is very little chance of an increase in rates.

The problem with low interest rates is that when companies and individuals can lend money cheaply, they tend to make riskier investments. Some economists claim that low interest rate levels in the early part of 2000 were a major reason behind the subprime crisis. Banks had funds available to them at very little cost and they became aggressive by removing many of their lending restrictions.

The same irrational investing was seen during the dot com bubble, when large amounts of money went into companies with poor business models, just because the economy was awash with money. When the bubble burst, it wiped out trillions of dollars of market value of technology companies and thousands of investors lost money.

Along with low rates, there is another factor that could be fuelling bubble growth in some parts of the economy. To deal with the recession, the government had pumped in hundreds of billions of dollars in the economy as part of the stimulus package. This money is still circulating in the system, and it could go into certain assets that are already at inflated prices, such as gold.

The Fed believes that there is nothing to worry about yet. And as long as unemployment is high, all efforts should go into dealing with that problem instead of speculating about creation of new bubbles. This could be a short term view, but the Fed clearly does not have a lot of options. Raising interest rates prematurely could threaten the recovery and further increase unemployment, which would be completely unacceptable.