It may be wise to hedge against inflation in case the bubble bursts

Some believe the global economy has been cushioned from the effects of thelate 1990s bubble by the central banks and that the result will be a suddensurge in inflation.

The financial markets are becoming increasingly confident that the bear market in equities is over. The economic data suggest the world is enjoying a classic cyclical recovery, led by the US, but with a big supporting role played by the commodity demands of a fast-growing China.

This view implies that the effects of the late 1990s bubble have finally passed through the system. Although the pain felt by equity investors (particularly in technology) has been great, the economic damage has been mild.

But not everyone is convinced the world can get away so lightly. Some believe the global economy has been cushioned from the effects of the bubble by the actions of the central banks, the very banks that helped create the bubble in the first place.

In a new book, economist Tim Lee argues that the result of the bubble will be a sudden surge in inflation. "Inflation is the logical consequence of the long period of excessively loose monetary policies in the Western world," he writes.

"Inflation is also the way through which the financial bubble - in both bonds and stocks - can ultimately be deflated without a debt-induced total financial and economic collapse."

There is a case to make that the central banks encouraged the stock market bubble, not least by cutting interest rates sharply whenever prices were falling, as they did after the Long-Term Capital Management collapse in 1998. Investors were encouraged to feel that the banks had underwritten share prices, the so-called "Greenspan put".

However, that view raises the question of why loose monetary policies have not "leaked out" of the financial markets into higher consumer prices before now. After all, the flotation of Netscape, which arguably started the internet craze, was way back in 1995; eight years later, most consumer price indices are still flat as pancakes.

Lee's answer is that the bubble temporarily distorted the demand for money. "In a structural bubble, the demand for money becomes, or is likely to become, part of the bubble as much as the demand for other assets. Because money is a substitute for the other financial assets, if they (that is shares and bonds) rise in price, then money is also likely to rise in price (or value). "

Although the equity market peaked in 2000, the bubble mentality was simply transferred to bonds (where the peak did not occur until the summer this year) and to residential property. Money has chased assets, rather than goods. This has staved off disaster in the short term, but at the expense of allowing debt levels to rise even further. The eventual collapse will thus be all the more painful.

Lee's book was written before the recent run of strong economic data, but it seems likely, based on his analysis, that he would believe the recovery is running on borrowed time. Indeed he thinks that, rather than experiencing an acceleration in trend growth during the 1990s, the US may have shifted to a lower growth rate during the period. This shift may well have fuelled the bubble.

First, he argues that a shift to a lower trend growth rate may be mistaken by the central bank for cyclical rather than structural weakness. This will encourage the bank to run a looser monetary policy than is appropriate. Second, if inflation is mis-measured, this lower growth rate may be accompanied by lower inflation, further persuading the central bank to keep policy loose. Third, a lower growth rate should result in lower real bond yields. Markets may well treat these as justifying a lower discount rate for equities (and thus higher share prices) without reflecting that it also implies lower real future profits growth.

A natural objection to this argument is that the published growth rates for the US in the late 1990s were strong (and the productivity numbers have even been good since the bubble burst).

Lee argues that the bubble inflated the productivity numbers because growth was so strong in areas such as fund management and investment banking. Second, he says the productivity improvement was cyclical rather than structural. Third, he argues that the productivity figures were boosted by the "hedonic" approach to statistics, under which an improvement in computer power is treated as a fall in prices. This may have falsely boosted the output numbers.

The Lee argument is tempting but dangerous. It could well be that the data have been showing us a false picture and that the benign combination of rapid US economic growth and low inflation has been an illusion. But when you start to dismiss all the data, you are heading down a dangerous road.

Lee also gives too short shrift to the arguments that globalisation may be keeping the lid on inflation. In just three paragraphs, he dismisses the idea of increased competition, pointing to the wave of mega-mergers in the late 1990s. One would like to have seen a more convincing rebuttal, bolstered with some facts about concentration in leading industries.

Nevertheless, it would be a mistake to dismiss his case out of hand. After all, central banks do seem to have shifted from fighting inflation to worrying about deflation, government deficits are soaring and commodity prices have turned up.

Furthermore, the long boom has left the world with an unprecedented level of debt. In the past, high debt levels have usually been eroded by higher prices. It would be an unwise investor who lacked an inflation hedge (and that does not mean equities) in his or her portfolio.

Why the Markets Went Crazy and What It Means for Investors, by Tim Lee, Palgrave