Don't Reinflate the Old Bubbles

By Steven Pearlstein
Wednesday, October 14, 2009

Analysts at Goldman Sachs suggested Tuesday that, despite a 50 percent run-up in stock prices that has left the Dow Jones industrial average just shy of 10,000 and the S&P 500 selling at 20 times earnings, stocks are still cheap. In fact, according to Goldman, stocks are so cheap that corporations are going to start using all that cash on their balance sheets not for product development or marketing or some other productivity-enhancing investment, but for acquiring other companies.

In case you just fell off a turnip truck, you might think "Monetizing the M&A Revival" is serious research aimed at helping Goldman clients figure out how to profit from these uncertain times. The helpful analysts from Goldman even provided the names of companies they think are so underpriced that they are ripe for a takeover -- companies like Devon Energy, AK Steel and Red Hat.

But those with any memory at all will probably recognize this report for what it really is: a marketing brochure for Goldman's investment bankers, who are just itching to begin cranking up the old M&A machine and generating those big fees again. With deal flow, of course, comes an equally lucrative flow of new stock and bond issues to pay for all those ill-advised and overpriced acquisitions, along with increased volume on Goldman's trading desk from speculators hoping to cash in on the latest takeover rumors.

Just because Goldman is recommending this to its clients, however, doesn't mean Goldman is putting its own money behind the new bull market in mergers and acquisitions. Indeed, it is just as likely that Goldman is preparing to short the very takeover stocks it is touting to the public, just as it did in the late stages of the real estate and mortgage bubble. It's all perfectly legal. And it is perfectly in keeping with what we know about Wall Street's most successful firms, which is that if they stumble on a profitable trading strategy, the last person they are likely to share it with is you.

What we're witnessing here is pretty simple: another bubble in financial assets. All that "liquidity" created by the Federal Reserve and other central banks has accomplished its task and prevented a global financial meltdown. But unless they move now to begin sopping up that liquidity, the central bankers run a serious risk of reinflating many of the same bubbles that got us into this mess in the first place.

Many analysts now look at the economy and conclude that unemployment is still way too high and the threat of inflation still way too low for the Fed to even think about beginning to raise interest rates again. By one calculation, the appropriate federal funds rate today would be something like negative 5 percent. Since that's impossible, the Fed has signaled that it would not only stick by its zero-interest-rate policy for the indefinite future, but also will continue to inject additional money into the financial system by using freshly printed dollars to buy up the debt issued by government-owned Fannie Mae and Freddie Mac.

The problem is that because we didn't get into this recession in the normal way, the normal analysis and remedies are not appropriate. Slow growth and high unemployment are indeed going to be a big problem over the next several years, but they aren't going to be solved by pumping out lots of cheap money that is used to speculate in stocks, bonds and commodities rather than be invested in the real economy. And if all this speculation has the effect of driving up the price of commodities and driving down the value of the dollars we use for imports, then it is perfectly possible to wind up with high inflation and high unemployment at the same time -- as happened in the late 1970s.

The right policy response is for the Fed to begin withdrawing some of this extraordinary monetary stimulus even as the rest of the government steps up its effort to stimulate the real economy. That means more money for extended unemployment benefits; more aid to the states so that they can maintain the most vital public services; and more money to expand mass transit, state college and university systems, efficient energy production and basic scientific research. The economist Paul Krugman estimates that for every dollar in extra debt that will be required to finance this fiscal stimulus, about 40 cents will be repaid almost immediately in the form of tax revenues from higher short-term economic growth. And if the money is invested wisely in quality projects with high returns, the other 60 cents could wind up being a boon to future generations, rather than a burden.

What would surely not be good policy, by the way, is to extend and expand the current tax break for first-time home buyers that is set to expire at the end of the year, as many in Congress are now advocating. Home buyers are already getting a huge benefit from the dramatic drop in house prices, along with the lowest mortgage rates in a generation, thanks to massive government infusions into Fannie and Freddie. For the government to go beyond those efforts and try to induce home sales that otherwise wouldn't have happened -- at an estimated $75,000 a pop -- would surely be cheered by home builders, real estate agents and the analysts at Goldman Sachs. But in truth it would be nothing more than a misguided attempt to reinflate another bubble.

Steven Pearlstein can be reached at

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