Financial News, a Dow Jones Company, 14th December 2009
Central bankers, in particular the Federal Reserve, are those primarily responsible for the current mess in which we find ourselves. Their key error was to claim that asset prices didn’t matter and, to make things worse, by acting as if they did matter when they fell but not when they rose. This policy drove the US stock market to its most overvalued level ever in 2000. When the bubble collapsed, it required a major cut in taxes and extremely low interest rates to prevent the economy from going into a major recession. But the cost of this policy was very high, because it produced another asset bubble which broke in 2007 and which included not only shares, but houses and credit assets. When this bubble burst, the economy went into deep recession and it took even more fiscal and monetary stimuli to engender recovery than it had after the post-2000 bubble collapse.
It is obviously vital that we learn the lesson of these bursting bubbles. If in the next few years another bubble is allowed to develop and then crashes, its consequences are likely to be even worse than our latest bout of troubles, as the scope and efficacy of further fiscal and monetary stimuli are likely to be less than they have been this time.
The aim of policy today should thus be to secure a slow rather than a rapid recovery, free from any asset bubbles. My fear is that central banks and governments want a rapid recovery with bubbles, but my hope is that they will nonetheless achieve the desired result by a mixture of luck and incompetence.
The massive fiscal and monetary stimuli have, so far, had the desirable result of ending the precipitous downward plunge of the economy, and buying by the Federal Reserve and the Bank of England under the name of quantitative easing has pushed up asset prices. So far this has been a desirable process, as asset prices have an important impact on the real economy, giving confidence to companies about their plans for employment and investment and to households over spending. The importance of quantitative easing for asset prices is shown by the way in which bonds, equities and gold have all responded. This is typical of a liquidity driven market. When a rise in asset prices has been primarily driven by changing attitudes to the economy, different asset classes usually move in different directions as falling fears of inflation will tend to help bonds but hit gold, while growing confidence over growth tends to favour equities at the expense of bonds.
Fears are now being expressed that the rise in asset prices has gone far enough and that further rises would take us into bubble territory. I think that these fears are completely justified. The US stock market is around 40% overvalued, which is high but well short of past extremes. A further rise of 15% from current levels would, however, mean that the market was around 60% overvalued, which on past experience would be dangerous territory.
But the rise we have had so far is not only a help to confidence, it enables companies to raise equity cheaply. We have an overleveraged world economy, not just in the case of UK and US households. For example, non-financial corporate debt in the US is at record high levels and banks worldwide have far less equity than they need.
Deleveraging is essential for sustained recovery. At the individual level there are two ways in which this can be done. One is by repaying debt out of cash flow and the other is by swapping debt for equity, by routes which include corporate issues and defaults of borrowers being financed through equity issues by banks. In aggregate, however, attempts to repay debt out of cash flow cause savings’ intentions to rise and investment intentions to fall. As, in the event, savings and investment must be equal, these intentions will be thwarted by the collapse of incomes unless the government offsets the impact by running a large budget deficit. Both of these routes to deleveraging are currently occurring, but the shift of debt from the private to the public sector is neither desirable nor sustainable. The greater the amount of equity that is issued, the less will be the need to rely on fiscal deficits to reduce the private sector’s burden of debt. The recent rise in share prices is thus very useful, but further rises followed by another collapse would not only be disastrous for the economy but would bring to a halt the necessary flow of new equity issues.
Not only do we need to avoid further marked rises in asset prices, we also need to avoid a rapid recovery, accompanied by a rise in inflationary expectations. This would cause inflation to pick up even if there were still large underemployed resources of labour and capital. Central banks would then have to slow the economy again to prevent a recurrence of the stagflation we experienced in the 1970s and early 1980s. Slow growth and rising interest rates would be the recipe for another asset collapse.
By good luck rather than design there is a good chance that the coming economic recovery will be slow and that asset prices will fall back from current levels. A slow recovery is probable for two reasons. First, credit is likely to be constrained by banks’ unwillingness to expand their balance sheets, which is an accidental benefit of the failure of governments to agree on the steps needed for banking reform. This leaves the banks knowing that they will need vastly increased equity ratios in the future without being forced to raise the money today. Secondly, at least in Anglophone economies, consumption is likely to be constrained by rising household savings’ rates, investment by excess capacity and government spending by budget problems. Growth will depend on rising net exports and thus rising net imports by the rest of the world.
I am therefore quite optimistic about the economy, assuming that banks remain unwilling to lend and quantitative easing is soon brought to a halt. Such economic optimism requires slow growth and disappointing profits. The most likely alternative is not, I think, sudden drop back into recession, but a continued rise in the stock market and a strong economy. This would, I think, be very bad news.
This article first appeared in Financial News on Dec 14, 2009
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