.. the Keynesians have overlooked a .. demonstrable pitfall of their own creation: something that I call "The Stimulus Trap." This condition occurs when an economy becomes addicted to the monetary stimulus provided by a central bank, and as a result fails to restructure itself in a manner that will allow for robust, and sustainable, growth. The trap redirects capital into non-productive sectors and starves those areas of the economy that could lead an economic rebirth. The condition is characterized by anemic growth and deteriorating underlying economic fundamentals which is often masked by inflation or asset price bubbles ..
The overall financial sector is equally addicted to cheap money. Banks have seen strong earnings and rising share prices in recent years. But their businesses have largely focused on the simple process of capturing the spread between the zero percent cost of Fed capital and the 3% yield of long term Treasury debt and government insured mortgage backed securities. As a result, banks are not making productive private sector loans to businesses. Instead, the capital is being used to pump up the already bloated housing and government sectors.
.. What would happen to the housing market and the stock market if interest rates were to return to those traditional levels? The red ink would flow in rivers. With yields rising and asset prices falling, how long would it take before the Fed reverses course and serves up another round of stimulus? Not long at all.
That means any talk of an exit strategy is just that, talk. Not only can the Fed not exit, but it will have to delve further into the stimulus abyss. While doing so, the Fed will continuously insist that the exit lies just behind an ever moving horizon. It will repeat this mantra until a currency crisis finally forces a painful exit.
Unfortunately, the longer the Fed waits to exit, the more painful the exit will be. But trading long-term pain for short-term gain is the Fed's specialty. In the meantime, Wall Street watches in uncomprehending stupor as the economy settles deeper and deeper into the stimulus trap.