The Bear Stearns bailout and the associated calls for further Federal intervention in the mortgage market have highlighted once again an eternal economic truth: in an era of excessively cheap money, only the money is cheap. Everything else — assets, business ethics, economic stability, support for free markets – becomes either horrendously expensive or wholly unobtainable.

It is not surprising that political support for free markets wanes in an era of excessively cheap money, because the markets themselves stop working to the advantage of society as a whole and become rent seeking exercises for the well connected. The equilibrium of the free market, in which all transactions are between willing rational buyer and willing rational seller, falls apart if buyer and seller are made irrational by monetary distortion. The standard free market model assumes money as a constant unit of exchange and store of value; there is no significant body of theory suggesting what changes are made to the model by allowing the store of value to fluctuate wildly or inflate itself out of existence. History’s experience, from Diocletian to the Weimar Republic and Argentina, suggests that pathological behavior will occur.

Most investors think of rising stock prices as an unalloyed boon, and so were little troubled by the stock market bubble of 1996-2000. Only when the bubble burst was concern expressed, and a frantic search for scapegoats undertaken whose most unlucky victim was probably Jeff Skilling of Enron, given a 25 year sentence for crimes that in a more civilized era would have been punished by a modest fine if at all. However the cost of the stock market bubble appeared to the public to be limited to its collapse, and the Fed was wildly popular when by energetic action on the monetary bellows it managed to reverse decline after the Standard and Poors 500 Index had dropped about 50%, instead of the 75% that would have been justified.

Even during this phase, monetary madness had its costs, apart from the resources wasted on mad dot-com schemes that had no possible economic justification. Business capital expenditure was excessive, and has in consequence been depressed since. Non-farm business capital expenditures totaled $1.31 trillion in 2006, up 13% from the $1.16 trillion of 2000. However that does not take account of inflation or economic growth; in reality the 2006 figure was 10.0% of Gross Domestic Product, almost 20% lower than in 2000. What is more, its nature changed; whereas in 2000 31% of capital expenditure was on structures and 69% on equipment, in 2006 38% was on structures and 62% on equipment. In terms of GDP, equipment spending fell from 8.2% of GDP to 6.0%, while spending on structures remained constant at about 3.5%.

In other words, capital spending on equipment, moving technology forward, dropped by almost 30% as a share of GDP between the economic peaks of 2000 and 2006 whereas spending on structures, goosed by the real estate bubble stayed roughly constant. In 1996-2000 capital investment was excessive, but even in the low interest rate boom year of 2006 it has been depressed by a hangover from the earlier boom. Maynard Keynes blamed the Great Depression on “over-investment” in the late 1920s; it was only one of several causes, but experience in Japan after 1990 and now in the United States suggests that investment bubbles are indeed followed by unpleasant hangovers.

For the man in the street, the first indication that cheap money had a cost came with the soaring price of housing. To the established and affluent, this too was an unmitigated boon; indeed they used it to borrow more and indulge themselves in an orgy of vulgar conspicuous consumption. Fort the young and less well-heeled, it was frequently a disaster. They were unable to make home purchases without taking on excessive mortgages; while the salesmen in the mortgage brokers convinced many of them that they would easily be able to service these mortgages. The grim reality that they were over their head must have occurred to most such stretched homeowners long before stories began appearing in the media.

A further cost of cheap money arose in the area of business ethics and practices. When money is cheap, adherence to sound principles of business conservatism is expensive. That’s why so many fads were able to grow to enormous size, both on Wall Street and elsewhere. It matters little that credit default swaps are an untested product that could bring down the world financial system if money is loose and there are fees to be earned by writing them. Ethics, too took a back seat during the boom – you didn’t get rich by a refusal to cut corners, and while money is cheap malfeasances can be covered up through additional borrowing and fiddling the books.

Another cost of cheap money has now become apparent: soaring commodity prices, far beyond the level at which producers are adequately remunerated. In theory, this could enrich commodity producing countries, most of which are relatively poor. In practice, commodity marketing is controlled by local governments and hence a commodity price bubble enriches only the governments, enabling them to engage in an orgy of corruption and wasteful social spending. At this point, misguided government subsidy and restriction polices in the Third World, allied to a cheap money fueled consumption boom, have disrupted world trade in rice, while misguided government subsidy programs in the United States (the ethanol program) have disrupted trade in corn. Both disruptions have produced enormous price spikes, causing hardship and starvation among impoverished populations dependent on those staples.

If commodity producing countries are democracies, their signals become corrupted, so that in periods of low commodity prices competent governments get thrown out, as in Argentina in 1999, while in periods of high commodity prices leftist kleptocratic governments get re-elected, as in Argentina in 2007. The pathetic performance of the Argentine economy since 1930 (before which it was very capably ruled by an undemocratic but benign oligarchy) is due entirely to this fact – periodic commodity booms reward whichever government is in power, however incompetent, while slumps destroy any attempts to produce sound policies. The legend of Evita Peron depended crucially on price trends in Argentine commodity exports.

Finally, we come to the effect of cheap money on politics. Investment is being misapplied, vast fortunes are being made by fast-buck operators with unsound methods and minimal business ethics, commodity and energy prices are soaring through the roof and real living standards are increasing sluggishly if at all, since capital investment is depressed and productivity growth low. Regulation is tailored to suit the self-enriching classes through bountiful political donations. It is little surprise in these circumstances that the voting public loses its grudging respect for the free market, which appears to have produced a casino rewarding everyone but themselves. Leftist nostrums, previously discredited through decades of failure, come back into fashion; the talk is of more government regulation, higher taxes and more social spending. To the extent that such policies are economically damaging, their long-term cost can be laid firmly at the door of the irresponsible cheap money policies that produced a desire for them among the voting population.

This is where we are currently. We have finally exited the period of increasingly unsatisfying euphoria produced by the cheap money policies followed since 1995, and have entered full hangover mode. Calls are being heard to re-regulate Wall Street – as if government was any more capable of controlling the alphabet soup of gimcrack financial innovations than were their inventors. The only significant policy response to economic downturn has been a “stimulus” attempt to bribe voters with their own money, further increasing consumption, bloating the Federal and trade deficits and delaying the re-equilibrating of the US economy.

Regrettably, none of the three remaining Presidential candidates has focused blame on the Fed, where it belongs. Ron Paul, who did so, was universally derided by the commentariat although rather more successful with the voters. John McCain seems likely to offer more spend-inflate-and-invade rightist populism of the George W. Bush variety, although he may sweeten the mix with tax increases. Hillary Clinton offers not the “Washington Consensus” over-expansive free-market Whiggery of her husband’s Presidency, but a more protectionist policy mix, with much higher taxes. Only Barack Obama seems to have recognized that the Clinton and Bush Presidencies have considerable commonality, and that the impoverishment of the US workforce that he bemoans did not begin sharply in 2001. He does not yet have sensible remedies. However there must at least be some hope that he will come to recognize the centrality of the Fed’s cheap money policies in the US economy’s problems, and move to replace Fed Chairman Ben Bernanke with someone who believes in sound money and real interest rate levels that reward saving and discourage excessive consumption and wasteful boondoggles.

The market will eventually terminate the easy money experiment with a burst of higher inflation, which has been delayed this long only because of the deflationary effect of global outsourcing. However, it would be nice if we don’t have to endure an entire decade of high inflation, wasted resources and chronic recession before the Fed finally gets the message, as it did in 1979. We have suffered the costs of cheap money long enough; let us not endure another decade of them.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)