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The trouble with bubbles: they’re bursty

The trouble with bubbles: they’re bursty
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First Published: Tue, Nov 17 2009. 08 59 PM IST

Updated: Tue, Nov 17 2009. 08 59 PM IST
The ads have begun again. Real estate sales pitches that promise a return of more than 15% a year on “investment” in a new development. And insurance plans that promise 25% returns over the next 15 years. The financial crises is over and we’re back to the world as it was before Lehman. To see why this is incorrect and we are bang in the middle of the next bubble (also called echo bubble—or one that follows a large burst bubble) we need to see the face of those blowing.
First stop. Why do we pay interest? Suppose you lend me Rs1 lakh. After a year you’d want more than that back, right? Three reasons. One, I have to compensate you for pushing back your use of that Rs1 lakh by a year. Two, by the time I return this Rs1 lakh, prices would have risen making you buy less with it, so you need more. Three, I may run away with the money and you need to be compensated for taking this risk. Not called the “price of money” for nothing, the rate of interest is the price I am willing to pay you to use your money for a year. The higher this price of money, the less confident I would be of being able to return it, with interest, to you and more reluctant to borrow. But what if this price was kept low by design by twin forces of monetary policy and savings from another country flowing in (more of this below) to give a false sense of cheap cash? I’d borrow more and fling cash around to see where it came back with some return. In short, take much more risk than I should.
Now imagine a country that gets money to consume. That’s right. Savings of another country fund consumption of this rich country. Here is how it happens. This country consumes more than it produces. The balance flows in (mainly) from across the world and gets paid for in dollars. These dollars are not spent in-house, but are used to buy US bonds. Now the dollars paid for goods flow right back to the consuming country, for more consumption. Which gets more dollars, and then bonds and then on and on. In effect, the average Chinese saves to fund the average American buying her 65th pair of jeans.
Piece three. A web of fibre optic cables gets laid under the oceans some years ago that allows the whole world to link up with each other. Real time. Now money is a cursor on the computer. The one that is linked to millions across the globe. Trades now take a heart-beat to execute. The fourth guy then comes on stage. He’s the risk incinerator. He takes risk, powders it and then spreads it around. He’s the guy who bought all the high-risk debt, mixed it with good debt, sliced and diced the portfolio, got a credit rating agency (hello, why are they still running around unleashed?) to say that this mess of gloop was actually the best quality investment opportunity (almost as good as our humble Public Provident Fund).
And under this frantic cloud of money fumes lies the real world. Where mum and dad go to work and kids to school. Dogs, when not dying of tick flu, are napping. All the while, the other world of money fumes. Laptop keyboards can barely contain the pull of cheap money begging to earn a tick or two over the neighbour. The flood of on-sale money, like a mutant amoeba, looking for the next morsel of return to consume. So, we’re in 2007. And there is plenty of gloop and cash sloshing about the innards of the global financial machine. Greenspun greenbacks wash the trading terminals with deals that dearer money would have panicked to see.
So cheap money circles the globe, faster and faster. And then one Ninja (no income, no job) guy in Minnesota defaults on his mortgage payment and interest rate rises by a tick or two. Money, oh God, suddenly has a price. As the imaginary world of zero risk implodes, the real world gets crushed. Mum and dad lose jobs. Kids, like, learn to forget about the 68th pair of jeans. And dogs in Manhattan don’t do spa no more. Sigh. The world is dying and the only way to revive it is to work the printing presses so that Helicopter Ben can shower cash on the comatose world. He does. And now over a year since Lehman and the shower of cash, a total of $3 trillion (according to the CNNmoney.com’s bailout tracker http://bit.ly/sCGH) has been injected.
It’s 2009. November. Nothing has changed. But now there’s a fifth joker on stage. A carry trade in dollar. This just means that money is free in the US and the dollar is losing value. You borrowed Rs1 lakh for zero rate of interest. And three days later when you pay it back, you return less than Rs1 lakh because the dollar lost value. Not only is money cheap, there is money for you to borrow. Wow. Capitalism rocks. And this money, carrying a dowry, is chasing assets globally again.
And so the ads about overpriced real estate in Manesar and Meerut have begun. As have the pitches from insurance companies. Bubbles can grow to amazing sizes before they burst. No telling when this one will. But bubbles. They’re bursty.
Monika Halan works in the area of financial literacy and financial intermediation policy. She is consulting editor with Mint and adviser, Pension Fund Regulatory and Development Authority. Comment at expenseaccount@livemint.com
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First Published: Tue, Nov 17 2009. 08 59 PM IST