The bad precedents

Historically, when governments have turned to competitive currency devaluation as a last-ditch effort to boost growth and avoid tax hikes and spending cuts, the results haven't been pretty. Weimar Germany's efforts to inflate away war debts and rebuild after World War I come to mind. The abandonment of the gold standard in the 1930s, to cite another example, was followed by currency devaluations, protective tariffs, trade wars and a deepening of the Great Depression.

A few officials at the Fed and European Central Bank pay heed to history's warnings -- or at least say they do. ECB President Mario Draghi said earlier this week that he is aware of the challenges presented by a protracted period of near 0% interest rates, including the negative impact on savers and the risk of bubbles.

And I think a brave speech by Cleveland Fed President Sandra Pianalto last week underlines this point. She highlighted what's become patently obvious for those who are skeptical of optimism surrounding Dow 14,000: Aggressive central bank stimulus, like everything else in the realm of economics, is subject to the law of diminishing returns.

In plain English, the risks of more money printing are beginning to outweigh the benefits.

A look at the risks

Pianalto outlined four distinct risks that are rising:

  • Credit risk. The danger here is that with interest rates so low, banks and other institutions could "reach for yield," using cheap money from the Fed to take on more dangerous investments as they try to boost their returns. The Fed's use of low interest rates in 2003 to 2005 resulted in this, magnifying the housing bubble as banks, and then investors, gobbled up higher-risk mortgages offering higher yields. This could fall down around them if the economy weakens and defaults increase.
  • Interest-rate risk. This means simply that with rates so low, people aren't prepared for a surprise rise in interest rates -- which would send bond prices down hard.
  • Risk of market turmoil. The big fear here is that financial markets could become distorted because of the Fed's large and growing stake in the Treasury and mortgage bond markets as it buys up bonds to push money into the economy.  The risk rises as central banks around the world use similar strategies.
  • Inflation risk. Finally, all of this cheap money could result in a loss of control of inflation. Gas prices are surging already, as shown in the chart below. Chinese monetary authorities earlier this week restarted a program to drain money from China's financial system for the first time in seven months -- ostensibly to address inflation worries.

$GASO Gasoline Unleaded

No doubt higher gas prices, combined with higher taxes, have weakened consumers to the point that Wal-Mart Stores (WMT) executives called its month-to-date February sales a "disaster" in emails obtained by Bloomberg News last week. Foreign consumers are under pressure, too, with European car sales posting their worst January drop on record, falling nearly 9% from the same period in 2012.

We're already seeing these risks play out. It's starting with inflation, which I believe will damage the economy to the point that defaults rise and market turmoil increases.

The scary thing is what happens if this continues. Pianalto suggests the Fed should slowly reduce its bond purchases to reduce these risks as the economy strengthens. But what if it's too late? Already, 45% of the countries in the Organisation for Economic Co-operation and Development are in a technical recession, defined as two consecutive quarters of negative growth of gross domestic product. What will the Fed do if we follow them into a new downturn?

With monetary policy already at full throttle and potentially contributing to a downturn, where do the Fed, other central bankers and political allies go from here?

Should they pray harder at the altar of cheap money, or try something else? My hope is they will back off and look at our structural problems: inefficient and overpriced health care, substandard education, poor infrastructure and nervous executives withholding needed investments.