Governments across the world have initiated actions that have allowed markets to ignore many of their basic problems. More money is not the answer—it is making underlying problems worse 

The market volatility of the past week is hardly surprising. The only thing that is surprising is what took it so long. The flood of free money over the past year has allowed markets to wallow in profits from all sorts of 'risk on' bets. Everything from obscure commodities to emerging market bonds benefitted from this speculative orgy. These distortions caused by government action allowed the markets to ignore many of the most basic problems. The list is certainly long.
 
Last week it was the US government's irresponsible handling of its debt negotiations. This week it is the seemingly interminable debt issues in Europe. Then there is the very real problem of weak growth or perhaps outright recession. Still the market cheered when the Federal Reserve promised to keep interest rates low for another two years. They should have panicked and sent the market down another 10%. More money is certainly not the solution. Instead it may be making the problem worse, much worse.
 
Over the past 25 years, central banks' prime directive has been to avoid recession at all costs. As soon as the equity markets take a slight dip, the central bankers are there to flood the markets with money. Interest rates plummet and everyone jumps back in. The recession may be avoided, but the collateral damage has been bubbles, which exacerbate the next downturn.  
 
But you cannot just blame it on the developed countries' central banks. After the crash in 2008, China went on a massive stimulus binge of its own. Starting in 2009 its state-owned banks lent out a total of 21.3 trillion yuan. In 2008, the total lending was only 583 billion yuan. So just the bank-lending alone has been over 14 times the normal amount. Worse, the bank lending does not include loans from non-banks and the shadow banking system, which could almost double the numbers. The combination of cheap money from developed countries together with over-stimulus from China has created a host of unintended consequences.
 
One of the main consequences has been inflation. The Chinese just reported another month of rising inflation, which analysts brushed, off citing pork prices. Nothing could be more absurd. The Chinese are trying to control it through regulations with things like price controls which never work. For a variety of reasons hiking interest rates are ineffective. As Nobel Laureate Milton Friedman pointed out, "Inflation is always and everywhere a monetary phenomenon".

Despite a year and a half of tightening the amount of loans in China is still on track to be about the same as last year. The result is intransigent inflation and a real-estate bubble.
 
China is hardly alone in dealing with inflation. Almost all the emerging markets are being suffocated with cheap money and overheated economies. To deal with it, central banks around the world-with the exception of the United States-are raising interest rates. But these rate rises could cause severe issues for the real problem underlying slow economic growth: debt.   
 
Economic downturns are the plumbing of capitalism. When money is allocated inefficiently, during a recession, uncompetitive firms and sectors fail. In most instances both investors and creditors of the failed firms pay a price. They lose money. Eventually the market reaches equilibrium and growth can begin again. But thanks to misguided attempts to prevent recessions, this has not occurred. The US is still mired in a housing crisis. Europe is saddled with over-leveraged countries. Japan is still stuck after 20 years.
 
Free money has now spread debt bubbles around the world. New consumers in emerging markets have borrowed more than they can pay back. The result is a rising mountain of new debt. In Poland, over the past 6 years, the amount of mortgage debt grew by 728%. In Brazil, despite some of the world's highest interest rates, consumer debt has increased 100% since 2007.
 
Of course, credit bubbles spawn bad debts. Consumer defaults in Brazil are expected to increase by a third this year. In March the State Bank of India reported that its net profit for the quarter was nearly wiped out by provisions for bad loans. Meanwhile the bad loans to local governments in China could equal 8% of GDP (gross domestic product).
 
But that is not the bad news.
 
The bad news is that the legal mechanisms for clearing the debt like bankruptcy and foreclosure simply don't exist in emerging markets. These economies do not even have information reporting mechanisms like credit reporting agencies. So the markets do not really have any idea how large the problem is.
 
So instead of solving the problem, cheap money has and will make it worse especially in emerging markets, the recent source of global economic growth. As interest rates rise, the true damage will become clear. The overdose of cheap money medicine will kill rather than cure.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)