Recovery or Bubble? C.P. Chandrasekhar

Fears of a new speculative boom on which the global recovery rides are being expressed in different circles. There are as many aspects to these fears as there are to the so-called recovery, which include the huge profits being recorded by some major banking firms, the surge in capital flows to emerging markets, the speculative rise in stock markets’ values worldwide and the property boom in much of Asia. Potential victims of the reversal of this boom, however, now complain that the source of it all is a return in the US to a policy of easy money—involving huge liquidity infusions and extremely low interest rates—to save the financial system and real economy from collapse, while resorting to a fiscal stimulus to trigger a recovery. A similar policy was and is being adopted by many other countries, even if not with the same intensity in all cases, but the US, which was home to the most toxic assets and damaged banks, led by a long margin.

This policy did generate the signals that suggested that economies were on the mend. But these are also signs, argue some, of a bubble similar to the one which generated the high profits and the credit-financed housing and consumer-spending boom that preceded the 2008 downturn. That dangers associated with that bubble were ignored because of the short-run growth benefits it delivered. This one could be ignored because of the impression of a recovery it generates. Even as satisfaction is being expressed in some quarters about the recovery, however halting, fears of a second downturn or double dip recession are being expressed in other circles. Thus, just before the US President Barack Obama arrived in Beijing on his much-publicised visit to China, that country’s banking regulator, Liu Mingkang, criticised the US Federal Reserve for fuelling global speculation by adopting a loose money policy to save financial firms. This view was soon espoused also by Wolfgang Schauble who criticised the US Federal Reserve’s role in fuelling the dollar carry-trade, which involved borrowing dollars at low interest rates to invest in higher yielding assets outside the US. Investors resorting to such trades not only benefit from the spread between the low interest rates on the borrowing and the higher yield on their investment, but also from the depreciation of the dollar in the interim, which requires, say, fewer euros to buy the dollars needed to repay the original loan.

The direct and indirect links between the fiscal stimulus, a loose money policy and the revival of bank profitability is well known. Directly, a part of the “stimulus” involved using tax payer’s money to invest in banks or institutions like insurance giant AIG. The former kept banks solvent even when they were writing off bad assets, while the latter helped non-bank institutions meet commitments on failed assets, without which banks and other financial firms would have been driven to bankruptcy. In addition, the government had implicitly picked up a chunk of the bad debts of financial firms seen as too-big-to-fail by offering guarantees that sustained their value on the books of banks. The initial return to profitability that this ensured seemed to have improved the market value of bank equity, making it appear that the government may in fact recoup or even make money on its investments in bank capital. But as economist Dean Baker had noted some time back: “This is a case of money going into one pocket but out of the other one; that’s not the way that most investors make money.” No less a person than George Soros told the Financial Times (24 October 2009) that the profits made by some of Wall Street’s leading banks are “hidden gifts” from the state, and taxpayer resentment on this count is “justified”.

But state support for the banks did not end here. The Federal Reserve chipped in with the easy money policy mentioned above, which helped drive short-term interest rates to near zero. In the event banks could ride the sharp yield curve, borrowing cheap and investing in more long-term assets that offered higher returns. Some of these, like government bonds, were low risk investments offering returns of 3 per cent-plus, and the net interest margin that the government was handing out to the banks was a sure way of making them record profits.

But clearly, the banks, especially investments banks like Goldman Sachs, were not going to stop here. Rather they chose to go further and use this cheap money to speculate in stock, commodity and property markets, wherever they appeared profitable. Though this was more risky, the bets were likely to pay off for four reasons. First, even within the US the stock market was at a low, with much-fallen price earnings ratios. Any improvement in corporate profits as a result of the fiscal stimulus would improve stock prices, so investing in the market was seen as safer than it was in a long time. Second, this was true even of commodity markets like oil and food, and there were always commodities which had not been through that cycle and were ripe for a boom, including gold which would only rise if the dollar weakens because of the excess dollar liquidity that was being pumped into the global economy. Third, many emerging markets were affected less or hardly at all by the recession, making their stock, bond and property markets attractive destinations for investors with access to cheap money. Finally, the rush of capital to these markets in itself fuels a boom that attracts more capital inflows and fuels a speculative spiral.

The consequence of these moves has been stunning profits for some financial firms, especially Goldman Sachs, and reasonable returns for others. We are also witnessing a return of the controversy surrounding bonus payments and high compensation provided to managers of banks that were rescued with tax payers’ money. Moreover, financial markets that had slumped have now revived with emerging markets witnessing a boom in some cases. Commodity prices are also once again buoyant, and property markets outside the US are experiencing sharp price increases. There are two ways to interpret these trends. One is to treat them as symptoms of the end of the crisis and the beginnings of a recovery. The other is to see them as the signs of a new bubble. Thus far the former view has dominated.

Needless to say, the cheap money that was pumped into the system has helped shore up real demand, which together with the fiscal stimulus has ensured that downturn has touched bottom and some economies are showing signs of a revival. In fact, in emerging markets and countries like China the inflow of liquidity and the local fiscal stimulus helped partly neutralise the adverse effects of an export slowdown on growth.

But now fears are being expressed and responses are being sought on a number of counts. One of course is evidence of a so-called “correction” in developed country stock markets since March this year: the S&P 500 index has risen more than 60 per cent, while the FTSE Eurofirst 300 has recorded a similar rise. But this is small compared to what is happening in emerging markets. Brazil’s benchmark Bovespa index has gained 76 per cent this year; that is, in terms of the real, the domestic currency. Those who converted dollars into reals and returned to dollars after booking profits gained 139 per cent as the US currency has depreciated significantly. Such opportunities have resulted in net inflows of a record $60 billion-plus into emerging market equity funds, which only serves to amplify them by driving prices further upwards. The second sign of an actual or potential speculative boom is the reversal of price declines in commodity markets, which though yet not alarming, revives memories of the fuel and food price spiral of a couple of years back, which is seen by many as having been partly driven by financial speculation. Oil for example is already trading at around $80 to the barrel in US markets. The third is evidence of a real estate bubble in emerging markets, especially in Asia. Thus, for example, the Financial Times (5 November 2009) reports that in Hong Kong, prices of apartments costing more than US$1.3m, which fell 6.2 per cent in the third quarter of last year, and were expected to fall by a further 40-45 per cent by the end of this year, are now 30 per cent more expensive than at their low point in the fourth quarter of 2008. Prices for private homes in Singapore reportedly rose 15.8 per cent in the third quarter relative to the second, and in China 37 per cent year-on-year. Finally, there is the global surge in gold prices as investors rush into the metal because of fears of a dollar decline. Gold is trading at around $1170 an ounce.

Put all this together and an emerging story of a new speculative boom and a fresh bubble driven by finance capital cannot be dismissed. As a result, there are growing fears of a second collapse. The liquidity created by the Federal Reserve is increasing the overhang of dollars in the world economy making investors more concerned about the likely depreciation of the value of the dollar. If they choose to rearrange their portfolios, which they seem to be doing, a further depreciation of the dollar is inevitable. If the US responds to such depreciation by raising interest rates there could be an exit of funds from global asset and commodity markets outside the US triggering a collapse that can have collateral effects that are damaging.

Besides this fear of a sudden capital exit, emerging market countries are also worried about the effect that a surge of dollar inflows into their economies is having on their currencies. The resulting appreciation is undermining their competitiveness relative to countries that are managing to keep their currencies pegged to the US dollar. One consequence has been a revival of interest in capital controls, especially after Brazil imposed a 2 per cent tax on foreign investment in equities and bonds to dampen excess capital inflows. Some Asian economies too are contemplating similar measures to guard their currencies and stall a speculative rush into financial and real estate markets.

The positive in all this is that lessons from the crisis that were quickly forgotten are being studied once more. Whether that would finally translate into policies that reduce the probability of another bubble that can go bust is, however, unclear.