"That the rate of interest will be lower when commerce languishes and when there is little demand for money, than when the energies of commerce are in full play and there is an active demand for money, is indisputable; but it is equally beyond doubt, that every speculative mania which has run its course of folly and disaster in this country has derived its original impulse from cheap money."

– The Economist, 1858 (h/t Jamie Catherwood)

1858. That 162 year old quote might as well have been written yesterday.

There is a particular lesson that history regularly teaches, yet the public never actually learns. The lesson is simple. When a) the government – or since 1913 the Federal Reserve – insists on making money cheap by aggressively suppressing interest rates, and b) provided that investors are inclined to speculate – an essential condition that we’ll get to shortly – the combination invariably produces an episode of “irrational exuberance,” often with a subsequent collapse that exerts economic damage far exceeding whatever benefits the depressed interest rates were intended to produce.

Specifically, provided that investors are not so risk-averse that they view low-interest liquidity as a preferred asset in itself, depressed interest rates encourage them to chase competing yields by bidding up the prices of speculative assets that they believe will offer them a “pickup” in returns. Once yield-starved investors surrender to the herd mentality, in the belief that depressed interest rates offer “no alternative,” the entire structure of the financial markets shifts away from productive allocation of capital toward yield-seeking speculation.

So investment banks and hedge funds become inclined to borrow money to speculate in “carry trades” that exploit small – but emphatically not riskless – differences in yield between different securities. Inefficient projects that would never survive the hurdle of normal interest rates suddenly become viable, particularly activities involving leveraged buyouts, speculative real-estate, and debt-financed stock buybacks, where interest is the primary cost of doing business. Wall Street becomes eager to pump out low-grade debt and sketchy new issues to satisfy the rabid demand of investors, who only seek relief from the yield-starvation intentionally engineered by the Fed.

Ultimately, the speculation drives prices high enough, relative to likely future cash flows, to virtually ensure zero or negative long-term returns on even those assets. But here’s the irony: everybody is happy. All anybody cares about is the ink on a piece of paper, or the pixels on a screen, that tell them that they own something of worth. Never mind that if they hold those assets over the long-term, they will earn nothing more. Never mind that in order to sell those assets, they will require someone else to step up to hold the bag. Never mind that if enough people attempt to sell without those greater fools absorbing the supply at nearby prices, a great deal of that paper wealth will vanish into thin air.

And when that collapse comes, as we observed most recently in 2008-2009, the other irony is this: everyone will look to the government and the Federal Reserve to save them: by making money cheap.