Blowing bubbles
November 16th, 2010
Most people now recognise that property and share values in 2007 were well into bubble territory in the west. As interest rates rose and liquidity was drained from the markets down came the prices of assets. The bubble collapsed, slowly at first and then rapidly towards the end of the Credit Crunch.
Regulators, central banks and governments shook their heads wisely after the event, disclaimed responsibility, blamed the bankers, and vowed not to let it happen again. For the most part they ignored their own role in allowing a big expansion of bank balance sheets. They after all created the cash and liquidity which fuelled the system, and talked blithely of a new paradigm which they said permitted all this to happen with no painful side effects like inflation.
Today they believe the opposite. They demand that banks hold more cash and capital. They warn against excessive use of options and futures, are more sceptical of securitisation, and propose much less private sector leverage. The private sector is told to live more within its means. Does this then mean no more bubbles?
If only. The authorities are tougher now on private sector excess credit, but in love with excess credit for the public sector. They are creating a bubble to cure the aftermath of a bubble. Today the news is all about more quantitative easing. This means authorities creating more money in electronic ledgers to buy up government bonds. As they do so the price of bonds rises and the government borrowing rate falls. It gives governments the feeling that they can afford more borrowing after all. On both sides of the Atlantic the main countries are issuing large quantities of bonds at low interest rates by historic standards. This is bringing on a government bond bubble.
All the time markets want to believe, and all the time inflation remains relatively subdued, they can get away with this. For countries with more extreme budgetary problems the markets have already called time on this approach, forcing down bond prices and demanding much higher interest rates before they will lend. Greece, Iceland, Portugal, Ireland and Spain have trodden this path. Others should beware – their luck will run out one day as well. Wise governments take action to curb their deficits before markets lose confidence. Wise governments budget for higher interest rates than today’s.
The paradox of quantitative easing now is it seems to have more beneficial impact on emerging market economies than it does on the slower growing western economies administering the stimulus. As the dollar fell in advance of the Fed’s decision on more easing, so money poured into the emerging market economies. Governments may think quantitative easing is good for domestic growth and believe inflation is no threat. Investors think otherwise. They are both running for cover in inflation protected assets like index linked bonds and gold, and putting their money to work in countries with higher interest rates and faster growth rates.
Too much quantitative easing to allow governments to borrow more could create another bubble. What the west needs is sensible banking regulation that allows sufficient capital and credit to flow to productive private sector uses to fuel the recovery faster. In the meantime we suggest investors steer clear of western country government fixed income bonds on low rates for long time periods. Emerging markets are likely to run further all the time money stays easy.
