Loose Monetary Policy Fueled Bubbles

Low interest rates, especially negative real interest rates create excessive risk taking because people are forced to reach for yield in order just to stay even with inflation. Look at the situation today and back in the early 2000's with the FED Funds set at 1%. The typical definition for the risk-free rate is the 90 day Treasury bill which closely follows the FED Funds rate. With inflation above 1%, anyone who wanted a safe return would have to guarantee themselves a loss. The only way to keep up with inflation and keep purchasing power is to make riskier investments.

Banks are not the only ones that benefit from low FED Funds rates. Corporate bonds and other financial instruments (such as mortgage bonds) are also affected and receive lower rates too. The higher the quality of the bond, the lower the spread between Treasuries and the bond. Today, highly rated and highly "safe" companies such as Microsoft are able to sell their five year bonds at below inflation. Once again, the investor has to reach for yield in order not to guarantee himself a loss.

Where to go? Humm, junk bonds offered around 7%, and back in the bubble, people couldn't get enough of those bonds. There was so much demand that artificial junk and subprime mortgage bonds were created. That's right, artificial bonds made from credit default swaps simulated the junk and subprime bonds because not enough real subprime and junk bonds were available. Do we see something here? There was so much demand for subprime "high" yielding debt that mortgage brokers were pulling in jobless people and giving them money to buy a home. That is people could get cash out in addition to owning the home!

There was no conspiracy, these loans were widely known and discussed because they were referred to as NINJA loans, no income, no job loans and that name itself should have been enough for any regulator or investor to understand what they were getting into.

Yes there is definitely a psychological side as well. People stopped pouring money into stocks after the tech crash and people are much more risk-adverse today, even willing to accept 0.01% on T-bills which is a guaranteed loss of more than 3% a year with inflation where it is. But I hope that you see how low interest rates create speculation because people are FORCED to take risks that they wouldn't otherwise to protect their savings and assets from being destroyed by inflation. Many people would have been happy getting 5% in a riskless T-bill, which is why the bubble popped right around the time the FED raised FED Funds to 5.25%. It's a complicated system with many feedback loops, but there is no question that loose monetary policy was at the center of the mess.