Imagine you are a central banker. You arrive at the office each morning and scan the daily financial pages and newswires. You read that markets—stocks, junk bonds, gold, oil—are positively giddy due to all the liquidity sloshing around that has to go somewhere, or something to that effect.
That would be the liquidity you created.
You may be starting to feel pangs of anxiety before you’ve had that first cup of coffee. You know from your crash course in economic-survival medicine that cleaning up after a burst asset bubble isn’t as easy as it sounds. If you learnt anything over the last two decades, it’s that today’s palliative can become tomorrow’s poison, that treating busts with prolonged periods of easy money leads to bigger bubbles, and that an ounce of prevention may prove to be the best cure.
So what’s a policy maker to do? The US economy is still facing major obstacles to sustained growth, credit isn’t flowing to sectors and businesses that need it, and the financial system is far from self-supporting.
Surely there’s a better way than orchestrating alternating periods of asset bubbles and busts.
Varying impact: Former Fed governor Frederic Mishkin says not all asset bubbles are equally dangerous. Carol T Powers / Bloomberg
It’s 2003 all over again, says William White, chairman of the Economic Development and Review Committee at the Organisation for Economic Cooperation and Development in Paris.
White was referring to the inflection point in 2003 when, following an extended period of ultra-low interest rates—1% in the US, 2% in Europe, close to 0% in Japan—monetary stimulus ignited a rally in asset prices, the mother of all housing bubbles and a crisis that brought the financial system close to the brink of collapse.
More of the same
It’s very tempting to do what’s worked before, even if it makes things worse in the long run, White says. We’re at the end of the road we embarked on in 1987, if not before, relying on credit bubbles, associated increases in asset prices and unwise spending every time there was a problem.
Lowering interest rates, expanding the federal deficit: It may work in the short run but in the long run (yes, we’re all dead, but our children aren’t) it creates a mountain of debt and a lot of stuff no one needs or wants.
No central banker or government official is brave enough to look the public in the eye and speak the truth, especially when presenting two, unappealing options: Either we suffer through a long period of stagnation, with easy money and government spending cushioning the fallout, even at the risk of creating new imbalances; or we take our medicine in one large dose and suffer a shorter, more painful period of contraction and restructuring that wrings the excesses out of the system.
Few brave men
It takes a very brave man if the choices are stagnation versus a painful adjustment, White says. I suspect there are no takers for the second one.
Perhaps that’s why former Federal Reserve governor Frederic Mishkin made an elegant yet tortured argument in Tuesday’s Financial Times on why today’s bubbly markets are nothing to worry about.
Not all asset bubbles are created equal or equally dangerous, Mishkin writes. In the bad category are credit boom bubbles, which involve increased leverage, higher asset prices and more lending against appreciating assets. Put the housing bubble into the bad and dangerous category.
The pure irrational exuberance bubble is less bad and poses less of a danger to the economy. Put the late 1990s Internet and technology stock bubble and the 1987 stock market bubble, both of which spared bank balance sheets, into this less bad, less dangerous category, Mishkin says.
If today’s stock and commodity markets represent a bubble, they’re not the worrisome kind, Mishkin assures us. At least not in the US and in Europe.
This may sound like a distinction without a difference, but it represents an evolution in his thinking from the outright denial of asset bubbles as destabilizing in a January 2007 speech.
It’s true that with bank credit shrinking, the bursting of any potential bubble won’t have the same ripple effect as the over-leveraged housing market. That doesn’t mean the persistence of 0% interest rates will result in efficient allocation of credit.
Zero percent interest rates and quantitative easing can work in one of two ways, White says. Either they have a direct effect on inflation expectations, prompting the public to spend today in order to front-run tomorrow’s higher prices; or they raise asset prices, which makes people feel wealthier and want to spend more.
Both channels pose obvious risks, but it’s so simple it might just work, White says, with a nod to Monty Python.
It might. On the other hand, it could end badly. Bubbles usually do.
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