In 2000 the stock market was in trouble. Several years of heavy speculation poured investment dollars into the stocks of companies that bled money. Many of these companies had nice ideas. Unfortunately they lacked one thing: profit.

In an attempt to hold back a serious economic depression the US Federal Reserve headed by Allan Greenspan dropped the target rate. They didn’t just tweak interest rates, they pulled the floor out from underneath them. The prime rate slid from 9.5% to a low of 4% in 2003. Te Fed’s target rate was down to 1%.

Money flowing out of the hot stock market was going into real estate. Low interest rates ignited several local real estate markets moving the speculation out of stocks and into real estate. At the same time, the money started flowing back into the stock market, pushing it back over 10,000 by late 2003.

From a distance, the US economy was looking good. Home prices were appreciating at record growth rates and it appeared the the stock market was finally recovering.

But was all well with the US economy?

By dropping interest rates the Fed floods the economy with easy credit. Easy credit means that a business or real estate project that may have not made sense earlier was suddenly profitable.

Economic growth means more jobs and more money is in the system. Isn’t this where we want to be?

Here is the problem — while the money supply can be increased at will, the limited supply of certain assets remains the same. Things such as real estate.. gold.. oil. The list goes on.

The problem is exacerbated because of the delayed increase behind employee wages. Thanks to other global trends, such as outsourcing, these wages may never catch back up. Are you starting to see the problem?

While Republicans have been willing to dismiss the “growing gap between the rich and poor” as Marxist propoganda, I no longer buy it. Well off individuals had a big advantage in this past real estate boom. Because many of them were already in real estate when it started, they had the beginners advantage.

The wealthy already get a large chunk of their income from investments. When the money supply increases, so does the paper value of these assets. The same can not be said of employees saving that money for retirement (if saving it at all)

When buying a new home the average consumer looks at the monthly payments — not the actual sticker price. Low interest rates meant they could leverage themselves into bigger homes. Combined with increased speculation this pushed the real estate market higher.

At first this appeared like an economic miracle. Increased home ownership and affordability was even praised by the President himself.

Then things started to look ugly. In the hot markets such as South Florida and California home prices started to be pushed to the brink of the average consumer’s affordability. The second generation of speculators were eagerly repeating out old wives tales such as “real estate never drops” and “location, location, location.” New home buyers were factoring in indefinate appreciation into their home purchases — completely ignoring the possibility of price drops.

Despite pullbacks that are already happening in the hottest markets it is unlikely that most Americans will see the bottoms fall out of their home’s dollar value.

Why? Because the Federal Reserve has been using asset targetting to set their target rates. That means they look at the stock market and real estate prices and adjust their rates accordingly.

This policy rewards speculation. The market responds to profits just as any rational individual would. Speculation is indeed an important part of any economy. Speculators make assets more liquid and assume risks bridging buyers and sellers. However, by stamping a guarantee on asset appreciation the Fed provides insurance to speculators; thats not their job.

In the next post I will examine the potential side effects of diverting capital away from sectors of the economy that meet consumer demand and into speculative assets. Note: this article was written on the way I see the US economy based on my personal observations both as an entrepreneur and student of economic theory.