The biggest bubble is subject to the smallest pin.

We all have heard stories about Depression-Era government officials pouring milk into rivers and destroying excess grain in order to help the economy. Some government actions are counter intuitive and seem grossly wasteful. The government sought to resist the market forces driving the price of food down because, it reasoned, falling prices were the cause of the depression. We know now, and should have known then, that pouring milk into a river did nothing to bring the country out of recession. Some government actions seem grossly wasteful because they are.

As the Federal Reserve gets ready to unleash a $1 trillion dollar tidal-wave of paper money upon the economy, I am reminded of those stories again. The Fed wants to prop up residential real estate prices and stock prices. In the Depression, the low price of milk might have hurt dairy farmers, but it was part of the natural market process to reallocate resources. In the market’s view, the only thing worse than idled workers and machinery, is the wasteful occupation of those resources in unneeded endeavors. By propping up the price of milk, the Government prevented the market from converting farm workers and farm machinery into more profitable fields. By continuing to make it ridiculously cheap to borrow money, the Fed is attempting to revive a residential real estate market. Using policy to inflate asset prices is just as wasteful and expensive as inflating commodity prices.

The price of houses needs to decline until the supply of houses naturally equalizes the demand. In some areas of the country, rows of gorgeous McMansions have never been owned by somebody who actually intended to live there. Instead, the McMansions were purchased by speculators who are now either bankrupt or unwilling to lower sale prices to a point where the scarce buyers will buy the houses. Let the price drop until someone can afford the house.

The paper money tidal wave is having another effect. Yes, in the next few months, we all anticipate that money will be easy and things priced in dollars will rise in value. But the money won’t rush into stocks because everyone remembers the effect of the last Fed pull-back. When oil prices reached their historic high, the Fed quietly began shrinking the supply of money leading to a chain reaction which ended with a massive collapse in equity prices. If you put your money in stocks and the Fed decides inflation gets out of control (and everyone believes this will eventually happen), you can expect another bubble-pop at the end of the easing. Thank you but no thanks. The more the Fed puts money into circulation, the more everyone assumes another bubble-pop will follow. The long money fears the bubble-pop and stays on the sidelines.

As I write this blog, the Chinese announced that its central bank raised interest rates by .25%. The stock market reacted by dropping 1.5%. Could this be a sign that the Chinese plan to blunt the easy-money policy of the Fed by luring greenbacks into Chinese savings accounts? It’s hard to say whether this is a major move or just a little pin prick. But when you’re suffering from bubble-phobia, a pin prick can look pretty scary.

Guest blogger- David Dawson.