Further asset bubbles appear inevitable

SERIOUS MONEY:Federal Reserve bailouts have contributed to an unhealthy disrespect for risk, writes CHARLIE FELL

RISK ASSETS of all varieties have enjoyed spectacular gains since the spring, fuelled by a tidal wave of liquidity unleashed by fiscal and monetary authorities in an effort to avoid a repeat of the Great Depression.

The gargantuan stimulus has been successful in paving a road to economic recovery. However, the speed with which excess liquidity has driven asset valuations back to the dangerous levels that prevailed prior to the demise of Bear Stearns and Lehman Brothers in 1998 is troubling.

Taxpayers’ cash was splashed among the Wall Street banks deemed “too big to fail” to strengthen their balance sheets. The funds have either been redeposited with the Federal Reserve as excess reserves or recycled into financial markets. The moral hazard created by the generous bailouts and the “too-big-to-fail” doctrine has contributed to an unhealthy disrespect for risk.

The financial conglomerates are once again generating record trading profits and have returned to business as usual enthusiastically, as if the past two years was just an unpleasant dream and not of their own making.

Indeed, Goldman Sach’s chief executive Lloyd Blankfein believes he is doing “God’s work”. But such arrogance was also apparent at the world’s first truly international deposit bank, the Knights Templar.

False accusations by king Philip IV of France however, led to the confiscation of their assets in 1312 and their last grand master, Jacques de Molay, was burned at the stake in 1314.

No such fate awaits today’s financial power brokers as the zero-interest-rate policy adopted by the Fed looks set to continue for some time, while the qualitative easing introduced in an effort to alter the relative pricing among different asset classes and maturities has transformed the Fed into a highly leveraged market-maker with its capital base at risk.

It would appear to have little incentive to take pre-emptive action and prevent the emergence of dangerous asset bubbles.

Indeed, the Fed’s unique and unconventional response to the financial crisis has seen the size of its balance sheet jump from $870 billion at year-end 2006 to $2.2 trillion today, an amount equivalent to roughly 16 per cent of GDP.

The monetary authority’s balance sheet typically played a minimal role in credit intermediation with assets for this purpose rarely amounting to more than half a percentage point of GDP.

The introduction of numerous special facilities has seen that figure jump to 12 per cent of GDP and its purchases of mortgage-backed securities, for example, are equivalent to roughly one year’s supply of new issuance.

The Fed is playing a dangerous game and further asset bubbles would appear to be inevitable.

The Fed will undoubtedly argue that its primary objective is to adopt a monetary policy framework that maintains price stability and, with the current output gap at close to 10 per cent of GDP, a high degree of monetary accommodation is necessary for a protracted period.

Indeed, prices provide households and businesses with the information they need to assess the relative value of goods and services, which ensures that resources are allocated to their most valuable use.

However, the information content in prices is degraded when the aggregate price level changes unpredictably and during periods of malign deflation and high inflation it becomes difficult to distinguish between relative prices that are advantageous and those that are disadvantageous.

The increased “noise” in prices leads to misinterpretation of the true signal and thus, to the inefficient allocation of resources and greater economic volatility thereof.

Price stability would appear to be a laudable goal as it contributes to greater economic stability and higher rates of employment.

The Fed, however, seeks to stabilise a price index of consumer goods and does not account for asset prices.

This has a detrimental effect on the allocation of resources over time as interest rates are held below the level that they would otherwise be.

The prices of long-lived financial assets move inversely to movements in interest rates and thus, holding interest rates below their natural rate generates asset bubbles.

Furthermore, asset bubbles can raise the natural rate as the profits on existing investments raises the expected return to future investments and fuels demand for credit, such that a central bank focused solely on consumer goods prices finds itself hopelessly behind the curve.

The asymmetric monetary policy overseen by former Fed chairman, Alan Greenspan, and certain to be repeated under Ben Bernanke, contributed to greater financial and economic stability below the surface.

Greenspan argued that asset bubbles could not be detected. The best the Fed could do was to “mitigate the fall-out when it occurs and hopefully, ease the transition to the next expansion”.

The baby-step interest rate hikes followed by aggressive monetary easing in the face of declining asset prices gave birth to the “Greenspan Put” and a classic debt-fuelled bubble, as described by the works of Hyman Minsky, began in earnest.

Minsky’s theories differentiate between three types of borrower – hedge, speculative and Ponzi.

The first has the ability to pay both interest and principal; the second can meet interest payments but relies on refinancing to meet maturing principal repayments, while the last depends on a continued rise in asset prices to stay afloat.

The economist notes that long periods of stability breed instability as the mix of borrowers shifts progressively from hedge to Ponzi.

The reckless abandon both of borrowers and lenders ends in an economic downturn that paves the way for the next recovery and expansion.

Minsky’s financial instability hypothesis is an apt description of the development of the recent financial crisis, but few lessons have been learned as giant bailouts and credit intermediation by the Fed have created further moral hazard and postponed the inevitable adjustment.

Asset prices may continue to diverge from the underlying fundamentals in the months ahead but a day of reckoning some time in 2010 or 2011 is coming.

charliefell@sequoia.ie