The failure of the G20 to tackle global macroeconomic imbalances means that surplus savings in net exporting countries will continue to inundate investment markets in net importing countries. Financial bubbles will continue to emerge and burst as a result. In the worst-case scenario, the global financial crisis could repeat itself, says Oxford Analytica in this complimentary download from the Alacra Store.
Research by Joshua Aizenmann and other authors has shown that current account deficits tend to enhance the real (price-deflated) appreciation of residential housing markets with a lag of up to four years, and that the effects of an increase in the current account deficit on housing prices are greater than the effects of a fall in interest rates.
Focusing more directly on the recent financial crisis, Riccardo Caballero and other authors have linked global macroeconomic imbalances to price bubbles in commodity markets, particularly oil. In 2002, Pierre-Olivier Gourinchas anticipated both the rise and fall of Greek sovereign debt markets.
The mechanism linking capital flows to financial bubbles is the ’search for yield’. It starts with a simple ‘convergence trade’, as money moves across assets with the same risk rating in order to take advantage of the convergence of prices from one asset market to the next.
This is easily seen in the context of the euro-area, where the existence of a common currency and integrated financial markets makes it easy for countries to export their savings without experiencing significant exchange rate risk.
The only way to protect against such bubbles is to be suspicious of any change in narrative, and particularly any story used to justify a significant discontinuity in the prices of what used to be closely correlated assets. Yet such an attitude would lead to conservative investment and lending practices — which Hyman Minsky recognised as a recovery phase in his financial stability hypothesis.
The problem with the Minsky psychology is that it only cleanses the markets of bubbles on the assumption that what started the problem in the first place was only a matter of narrative. Where there are real financial flows to be accommodated, Minsky’s psychology cannot overcome the search for yield and resulting low pricing of risk. In those cases, investors are likely to channel investments into assets that enjoy a widespread and pre-existing reputation as safe havens in crisis, such as US Treasuries and German Bunds, and especially gold. Such assets have a built-in justification for discontinuous performance. As a consequence, they are the most likely to experience price bubbles.
Failure to tackle global macroeconomic imbalances will create strong pressure on asset prices, possibly leading to bubbles. Given the ‘psychological’ state of markets, such bubbles are most likely to form around traditional safe-haven assets.