The Mother of All Asset Price Bubbles 13 comments
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Many, here and elsewhere, have argued that the stock market is overbought and due for a correction, but the market has nonetheless trudged along within its narrow band of about 500 DOW points. While its seems unable to climb above its ceiling of about 10,000 for the DOW, it is not collapsing either. Sideways movement largely predominates. But there is a problem.
The level of the stock market is clearly bubbled up. Few seem to doubt that especially given our recent 3Q GDP performance, properly viewed. The reason is the Fed´s current policies of a zero Fed funds rate, quantitative easing and very large purchases of longer term debt.
Together with credit easing, these policies are generating not only a massive outflow of funds into foreign stock and other financial asset markets via the carry trade, but also a massive inflow of capital into the U.S. by means of an accumulation of forex reserves by foreign central banks that are fed by that same carry trade and then used by those banks to purchase U.S. debt and other assets in the U.S.
This capital inflow is making it much easier to fund the federal deficits, but it is also creating and sustaining the stock market bubble. The dollar has not collapsed from the carry trade as those involved in it convert to local foreign currencies to buy foreign assets because foreign central banks have then used their forex reserves they get from that trade to buy U.S. debt and other U.S. assets.
Basically, interest free loans are being spread around the world like crazy and used to push up asset prices here and in foreign financial markets as well.
The stock market bubble is simply a part of an inflation of asset prices world-wide largely created by the Fed’s policies and the huge carry trade they have developed. The problem is Washington policy makers seem unaware of what is going on in these regards. They do not recognize the carry trade as being a problem because they do not focus on foreign central banks uses of their accumulation of forex reserves. They don’t keep track of foreign asset prices. They do not recognize the problem they are creating in world financial markets. They simply notice that their policies make it easier to finance the federal deficits and seem not to depress the dollar significantly.
This global asset bubble is no more sustainable in the long run than is the U.S. stock market is at present levels, absent a strong recovery. The problem will come when the Fed reverses its policies and begins reserve mop-up operations and raises interest rates. The carry trade will all but evaporate; foreign central banks will have their accumulation of forex reserves markedly diminished; the federal government will have a harder time financing its deficit without the Fed monetizing them, and the sea of debt that has been generated by the zero interest rate policy will undermine financial markets worldwide and will place a heavy burden on our government to manage its finances.
Like all bubbles, it will have to unwind. The question is how. If instability develops in world financial markets as the Fed reverses its policies, the likelihood of a crash in world financial and stock markets becomes more probably. As Nouriel Roubini sees it, we have created the mother of all bubbles, world-wide. It is unsustainable. It will collapse, the only question is will it unravel and collapse in a moderately orderly way or will there be a world financial crash.
Ironically, while recognizing that overleveraging substantially lead to the recent financial crisis on Wall Street, the Fed and the federal government have pursued policies which again have created tremendous leveraging, not only in the U.S., but in other world financial markets as well. At one level, it would seem that we did not learn much.
Given this mother of all bubbles and its global scope, I see no way that the Fed can effectuate an exit strategy that stands a reasonable chance of unwinding this asset inflation without precipitating a world financial crisis that could well dwarf the one we had on Wall Street with the credit crunch. The likelihood too it that it will clobber the U.S. recovery and compromise the projected recovery of world growth, presently estimated to be turning positive for the European Union (with Spain wobbling) and excellent for China. The IMF just raised its 2009 estimate for China to just shy of the 8.5 percent and noted the E.U. should fair better than earlier expected, too, and encounter less contraction.
But all this ignores the mega asset bubble that has been and is still being created.
It seems that, in our effort to escape from one economic mess – the great U.S. recession – we have created another one which threatens not only the U.S., but world financial markets now as well. At the same time, it is not clear that much has been done for the U.S. economy either, aside from pulling it back from the brink at the time of the credit crunch – no small feat.
However, GDP growth in the U.S. is seen to be flagging, once the 3Q number is more carefully analyzed, and the last thing the U.S. economy needs at this time or in the near future is another financial crisis.
But how else do we deflate asset price bubbles?
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This article has 13 comments:
America need not fear anything but fear the Federal Reserve and Washington. We are our own worst enemy.
Kimball, this isn't news. It's been happening, on a massive scale, since the 80s. It has nothing to do with the recently developed carry trade. To validate this, look at the capital account.
This is important because it points towards the real "mother of asset bubbles" i.e. the one that gave birth to the others. That mother is the US dollar. It has been propped up by these capital inflows for nearly 30 years. Those capital inflows, in turn, have been desperately looking for a dollar home. This has resulted in a Treasury bubble and other bubbles, such as housing.
This would not have happened if foreign central banks had sold their dollars as they received them. If that had happened, the world would now look very different. The differences would include:
- a lower dollar over the last 30 years
- US manufacturing and exports would have remained stronger, due to the lower dollar
- imports would have been lower
- unemployment would be lower as jobs would not have been exported to Asia
- base inflation would have been higher due to higher import costs
- higher inflation would have led to a higher average Fed Funds rate
- treasury yields would be higher, due to higher short term rates and the absence of Asian buyers
- higher yields would have discouraged borrowing and bubbles: investments would have to be discounted at higher rates of return
The US allowed foreign central banks to blow the dollar in to a bubble. Why object? It has given us cheap oil, low inflation, asian imports and lots of capital at cheap rates. But there's a price to pay. That price is the hollowing out of the economy and eventual devaluation. Then it's wake up time.
Asset bubbles usually deflate themselves, it is just a matter of time. On that point, although the markets have reacted strongly (positive) over the last few months, one of the things that I have seen is that there are worrisome signs of underlying weakness.
I have recently written of these signs; for those interested here is the link:
www.economicgreenfield.../
Gold and other commodities are the "relief valves" for paper money holders. Their prices still react to supply and demand, but demand is not necessarily for use but as a store of value. Other than gold, and to a certain degree silver and the platinum group, commodities eventually have to be used, so using oil for example, as a store of value is highly questionable. Yet what are the big holders of dollars to do? Jumping into the metals markets in any significant size will push prices to the moon. There is just too much paper money.
Buffett buying BNI is also a good example of moving out of dollars into "hard" assets.
Timing is always uncertain, but I would submit that some pretty sophisticated investors are bailing out and the day of reckoning may not be far away. Interestingly, this may not be all bad as stocks represent "real" assets as we have seen with BNI above. Buffett paid a 30% premium which makes one think he surely wants to gather as many assets as he can with depreciating dollars.
On Nov 04 08:45 AM chap08 wrote:
> "these policies are generating ... a massive inflow of capital into
> the U.S. by means of an accumulation of forex reserves by foreign
> central banks that are ... used by those banks to purchase U.S. debt
> and other assets in the U.S."
>
> Kimball, this isn't news. It's been happening, on a massive scale,
> since the 80s. It has nothing to do with the recently developed carry
> trade. To validate this, look at the capital account.
>
> This is important because it points towards the real "mother of asset
> bubbles" i.e. the one that gave birth to the others. That mother
> is the US dollar. It has been propped up by these capital inflows
> for nearly 30 years. Those capital inflows, in turn, have been desperately
> looking for a dollar home. This has resulted in a Treasury bubble
> and other bubbles, such as housing.
>
> This would not have happened if foreign central banks had sold their
> dollars as they received them. If that had happened, the world would
> now look very different. The differences would include:
> - a lower dollar over the last 30 years
> - US manufacturing and exports would have remained stronger, due
> to the lower dollar
> - imports would have been lower
> - unemployment would be lower as jobs would not have been exported
> to Asia
> - base inflation would have been higher due to higher import costs
>
> - higher inflation would have led to a higher average Fed Funds rate
>
> - treasury yields would be higher, due to higher short term rates
> and the absence of Asian buyers
> - higher yields would have discouraged borrowing and bubbles: investments
> would have to be discounted at higher rates of return
>
> The US allowed foreign central banks to blow the dollar in to a bubble.
> Why object? It has given us cheap oil, low inflation, asian imports
> and lots of capital at cheap rates. But there's a price to pay. That
> price is the hollowing out of the economy and eventual devaluation.
> Then it's wake up time.
This is a newer game and the zero interest rate policy, a newer policy. Earlier, the carry trade was less important because rates were not zero and banks actually loaned money in volume to people and did so quite liberally. Indeed, one borrower, name M. Mouse, got a sizeable loan, as did others also not qualified. That largely gave us the housing bubble, which was a different game than the one I focus on here.
Your specific focus was on the potential for creation of asset bubbles as a consequence of the continued use of stimulus measures to stabalize and restart economic growth. It may, however, not be possible to gear down stimulus measures until the recovery is on firmer footing. It follows that as the recovery gains strength, public authorities must be ready to begin addressing the debt bubble directly as it will only be in that way (however belatedly) that the asset bubbles you fear can be effectively addressed without triggering a return to recession or worse.
You observe in a previous article that since the time of the Nixon administration the US has struck a devil’s bargain (my phrase) on numerous occasions by simply re-inflating the economy whenever a recession occurred but by not then following through to address the accumulating structural and government debt problems attending these recessions. This is one pillar of the debt bubble edifice. The US low tax, low interest policy that marked these three decades (the tools of choice for staving off or ending recessions) over stimulated the US consumer market and international trade deficit and resulting debt imbalances (the cost of foreign regional wars also was a factor) thereby forming another pillar of the debt bubble edifice. The third pillar was created by the misguided US residential mortgage and consumer loan policies and the private sector debt bubble thereby created grew exponentially with the development by the US investment banking industry of massive volumes of secularized debt instruments and derivatives in an environment which increasingly disregarded questions of borrower credit worthiness and underlying asset value. EU nations adopted similar practices; generally to a more modest degree (although their investment banks in some cases were even more reckless).
Arguably, because of these growing imbalances, the global economy has been experiencing business cycles of increasing amplitude and at shorter swing intervals. While globalization has had benefits, this manic/depressive tendency of economic life is its downside and information technology now allows any panic to be instantaneously reflected world wide.
While it may not now be strictly necessary that the US domestic structural and government debt imbalances and the international balance of trade imbalance be substantially resolved for the current deep recession to be lifted (serial pseudo-recoveries of a partial and temporary nature having been achieved in the past, after all), you correctly observe that the economy will go back into crisis in a few months or years if these imbalances are not being significantly addressed. Thus, it will be folly if we simply at great public expense employ fiscal and monetary stimulus to prod the economy back into some semblance of a 2005 like normality. You therefore are forced to ask whether a massive liquidation of this debt bubble (and all that would likely imply in suffering and economic dislocation) is the only route out of the current impasse.
While the national debt and international balance of trade pillars of the debt bubble pose significant problems, the most intractable problem rests in the fact that a substantial portion of the debt represented by the third pillar (the largest of the three pillars) is currently (with cause) held by the market currently to have little in the way of sound asset backing. It is the existence of this ‘toxic waste’ that requires us to ask (however reluctantly) whether liquidation of this ‘third pillar debt’ (which would likely trigger the need to liquidate substantial portions of government debt and even to default on some international payment obligations) has become unavoidable. Arguably this is not necessary but it will be a near run thing.
To picture the route out of the impasse it must first be noted that a major part of the coordinated efforts of the international community over the past twelve or more months to stabilize the crisis has been the assumption by national governments of a portion of the ‘third pillar debt’ (temporarily if possible, permanently in unavoidable) from the investment banking sector. Objectionable though that has been, it prevented the collapse of commercial lending and therefore the economy generally. The fact this needed to be done undercuts any argument the banks, near banks and their advocates might otherwise wish to make that government does not have a stake and should not impose restructuring and regulation of the investment banking sector insofar as this is needed to resolve the debt bubble in an orderly fashion and ensure that such a bubble does not grow again. Also, it makes the case that the public sector, private sector and international trade balance aspects of the debt bubble are so intertwined that governments through internationally coordinated decisive action are entitled to intervene to ensure an orderly solution minimizing dislocation and hardship, It is no longer a question of free markets acting alone but rather of taking adequate and timely action to preserve an environment were the private sector can function freely in the future. OK, what about the toxic waste and excessive public debt (including international governmental debt)?
That resolution will involve some monetizing of the debt, some re-inflation of asset value, some carrying of the debt by the banks near banks and government and some default and bankruptcy in the bank and near bank sector. Monetizing raises the fear of inflation; repudiation by government the fear of catastrophic deflation but if (for a portion of the debt) both monetization and repudiation are done in balanced proportions over time through a coordinated international effort, excesses of inflation, deflation or international default can be avoided. Re-inflation of a portion of the debt bubble has been a vital byproduct of government stimulus since March of this year. Such re-inflation should be continued to a modest extent as it greatly reduces the need for defaults and bankruptcies and increases the capacity of banks and near banks to meet their obligations. At some point such re-inflation entails transfer to government and monetization of debt. This must be avoided except insofar as it is a conscious element of broader public policy for resolving the bubble.
Implicit in the forgoing is the need for national governments to work together to establish limits or a moratorium on the further growth of each of the three pillars of the debt bubble for, say, four years. These limits can be flexible (to prevent relapse into recession) but the goal must be to ensure that the difficult work necessary to address the currently accumulated bubble is not undone by further uncontroled building of debt.
The orderly bankruptcy or reorganization (either on their initiative, the initiative of their creditors or the initiative of public authorities) of some banks and near banks that contributed unduly to the build-up to the crisis is warranted as a means to pay down or repudiate debt that would otherwise be a public burden. It is the role of public authorities to ensure that these initiatives don’t trigger further crises and occur in a productive and orderly fashion.
On the international public debt front, it may be necessary for an orderly sequence of devaluations and renegotiation of the timing and reduction of payments to take place in tandem with the previously described addressing of private sector and domestic public sector debt bubbles. History shows that agreements to address these matters directly involving two or more nation of the first rank internationally are difficult to negotiate satisfactorily but that well organized multi-national conferences with lots of preliminary discussions (Bretton Woods comes to mind) provide the best setting for the achievement of this end. The key is that there is a common perception that agreement is vital, that no one nation be seen to be ganged up upon by the others and that no one nation sees its way clear to defy the common will without great cost to its international standing. If the need for such a thorough going international negotiation becomes apparent, the G20 could be the vehicle for establishing the necessary conference framework.
In sum, the resolution of the debt bubble is a many staged process that must take shape over an extended period of time. It will be difficult and entails risk. Through such a resolution process the specter of massive liquidation of private and public debt, repudiation of international debt obligations and uncontrolled devaluations of currencies can be avoided.