Speculative tsunami alert

It seems that interest rates around the world are going to stay low for a long time. The U.S. Federal Reserve seems determined to leave rates low in order to maximize liquidity for the time being, and the rest of the world can be expected to follow in its wake.

Low interest rates in turn affect yields on long-term government bonds, which remain relatively low despite growing national debts. And when interest on long-term government bonds is low, so is interest on corporate bonds. That in turn gives the companies a chance to borrow money at relatively low cost.

Many fear that the implementation of this sort of expansionary policy will, sooner or later, lead to an inflationary outbreak. It hasn't so far. Inflation seems to be under control. But that doesn't mean it will stay that way.

How could it be that the prices of consumer goods don't rise despite the massive amounts of money being printed? According to the textbooks, they should.

The answer lies in overcapacity - meaning that the supply of goods, or services, outstrips demand. That in turn creates deflationary pressures that balance the impact of the expansionary monetary policy.

That's a good thing, right? Cheap money encourages people to consume and companies to invest in new or existing businesses without paying a price in the form of inflation. But it's a good thing only on the surface.

Why? Because in an environment of overcapacity, investment does not generate a profit. Companies have no reason to invest in expansion, no matter how low the cost of capital. Overcapacity also means that more workers are sent home, which in itself diminishes consumer spending - it's hard to spend much when you're out of work - and that, too, has nothing to do with the level of interest rates.

This isn't economic theory, it's hard, cold fact. When we look at the behavior of many American companies in 2009, we find (with the help of their financial statements for the year) many common denominators.

To borrow images from the animal world, these companies are less like tigers waiting in ambush for prey and more like turtles retreating into their shells. They simply don't see any new businesses or investments that would generate adequate returns. So they savage their investments and pile up cash, even though such behavior bears its own cost. The companies are terrified of more recession ahead, and there's nothing like a pocket stuffed with cash to give that warm feeling when trouble lies ahead.

The problem is that if consumers and companies don't use their liquidity to increase demand and investment, real economic activity won't expand. That river of money will have to find some other place to flow to. That place is the speculative zone, or investment in existing assets that the owner hopes to hawk at a profit.

It's happening. There are few new ventures in the West but companies are changing hands, which does nothing to increase economic growth and employment. But money is cheap and investment funds have to do something with their cash stash.

We can see another example of the churn in speculation in commodities, which has dramatically increased. Look at the oil market, for instance, which is the biggest, most liquid of the commodity arenas.

In 1995, for each actual barrel of crude that changed hands each day seven virtual barrels were traded. Trade in the oil futures market was eight times the daily consumption of oil, by volume. That figure has continued to increase, rising to 1:10 in 1999, 1:13 in 2004, 1:25 in 2006 and to a stunning level of 1:38 today.

A decade ago minnow investors didn't dream of dabbling in oil futures, or gold futures for that matter. They probably wouldn't have known how to if they'd wanted. Also, buying an ounce of gold or a barrel of oil meant losing interest, so they had no reason to do so.

The commodities market has changed since then. The loss of alternative interest has become a non-factor (it's so low anyway). There are new financial instruments that enable anybody to speculate in oil or gold at the click of a mouse.

Since there is a secret little gambler hidden inside most of us, when the door charge for the casino is so low and there are no age limits or dress codes it's no wonder so many have jumped into the game. That's fine when the sums wagered are small. But the aggregate effect on the economy may not be small at all.

These are just a few examples meant to illustrate a single argument - that low interest rates do not trigger significant inflationary pressures.

That's the good news. The bad news is that it doesn't help real economic activity either.

So where do low interest rates have an effect? On speculation. It tends to increase.

The rate of risk-free interest is the benchmark for investors. It's their anchor. Today that anchor doesn't really exist, and investors find themselves swept off in all sorts of swirls and eddies.

And that means that many financial assets, be they stocks or bonds or commodities or real estate, may drift far, far from their fair value.

When you get nothing from a bank for depositing money in it, speculation looks all the more tempting. In these circumstances, investors would do well to exert self-control.

Meanwhile, the policymakers have to understand that there is a price to their actions. Right now the danger of inflation may seem remote. But there is a risk that their policies will trigger a speculative wave that does nothing good for the broad economy. With every day that passes, the probability of a speculative wave grows. We all know how waves like that end.

The author is the CEO of Psagot Compass Investments and head of the foreign equity research department at Psagot.