Sunday, November 08, 2009
Are central banks blowing new bubbles?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Another month, another 25 billion in quantitative easing from the Bank of England. The latest addition to the Bank's asset purchases will take the total to a nice round 200 billion.

The Bank seems to be winding down this phase of the policy, which began at a rate of 25 billion a month, then 50 billion over three months, and has now fallen to 25 billion over three months, assuming it lasts until February.

Given that the Bank seems to like operating in 25 billion units, logic would suggest that the process will end entirely in February, barring economic accidents. We may know more when the Bank publishes its quarterly inflation report this week.

Last week's move seemed well-judged. The question has arisen, however, about whether the Bank is part of a global conspiracy by central banks to drive up asset prices shares, bonds, property, commodities which is creating a bubble that will burst with devastating consequences.

Members of the Bank's monetary policy committee (MPC) are, of course, aware that quantitative easing is boosting asset prices. Indeed, it is an essential part of the policy, as described here last week, making it easier for firms to refinance themselves from equity and bond markets at a time when finance from the banks is rationed.

Some are concerned that this process should not go too far. Spencer Dale, its chief economist, warned in a recent speech that the Bank had to balance supporting economic recovery with the danger of pushing up the prices of shares, bonds and property too much.

"The substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify," he warned.

Nouriel Roubini, the maverick New York University economist, took this argument a lot further last week with an article in the Financial Times warning that America's Federal Reserve, through its actions and its influence on other central banks, was creating a "monster bubble".

Roubini described a gigantic "carry trade", which is when investors borrow in low interest-rate currencies to invest in other currencies and markets. Japan used to be the home of ultra-low interest rates and the yen carry trade was legendary.

Now the low interest-rate currencies are the dollar and sterling. The combination of these near-zero rates, a weak dollar and the willingness of the authorities to support every market in sight is fuelling a dangerous global bubble, Roubini wrote. "One day this bubble will burst, leading to the biggest co-ordinated asset bust ever."

He is not alone in expressing worries. The current issue of Newsweek has a cover story headlined: "Warning: we are in the next financial bubble". Its fear is of the echo bubble that usually follows financial bubbles. History tells us that such echo bubbles, like their bigger brothers, usually burst, though less violently and with a smaller impact on the wider economy.

American markets are up by about two-thirds from their lows, while emerging-market equities have risen by 95%.

We should take Roubini seriously. Though Bill White of the Bank for International Settlements probably got it more right than anybody, Roubini was one of the few other economists who warned loudly of the crisis.

His calls this year have not been so good, however, perhaps suggesting that he has become a bit of a stale bear. In March, close to the low point for global stock markets, he predicted further falls as a result of the likely nationalisation of several American banks and the continued contraction of the American economy to the end of 2009.

Part of the reason stock markets have risen so strongly since then is because predictions like that of a second Great Depression and further widespread bank nationalisation have not come to pass.

The second reason is that the recovery news has come through more strongly, for both economies and companies, than most people in the markets expected.
Some of the recovery in asset prices is therefore real, and welcome. We have come back from the edge of despair to the point where the world economy is growing again. It would have been odd if markets had not responded to that.

There has also been a return to something like normality in terms of the pricing of risk. Having under-priced risk in the run-up to the crisis, markets veered violently in the opposite direction, particularly in the autumn of last year. Even blue-chip borrowers were, for a while, treated like lepers.

The debate is about the extent to which, over and above this, central banks are dangerously inflating asset prices, creating the risk, not just of a bust but of more general inflation. Bearing in mind that central banks wanted asset prices to rise, they will have to judge how much is too much. My sense is that Roubini is greatly exaggerating both the extent to which all these market rises have been driven by central banks and the risks of a bust.

Most commodity investors, after all, survived a fall in the oil price from $147 a barrel in the summer of 2008 to well under $40. Stock market investors lived through its plunge until March. A reversal of some of these market gains at some stage is inevitable. I doubt, however, that it will give us a new apocalypse.

The main risk to the markets is economic. If the global recovery turns out to be weaker than expected, or if it cannot survive unaided once all the various stimulus measures are removed, then asset prices will take a big tumble around the world. A "W" for the economy would also be a "W" in the markets.

That is why central banks are determined to give their economies a big enough heave to try to ensure they have enough momentum to continue on their own. It is right, in my view, that at this stage they are more concerned about that than talk of blowing bubbles.

PS: Can the internet ever deliver fair competition? Some of you may have seen Dixons' advertising campaign, the one in which it encourages people to try out electronic products at posh stores like John Lewis, Selfridges and Harrods but then buy them online at Dixons.

The retailers concerned have objected, though Dixons, it could be said, is merely putting in black and white what many shoppers do anyway. At least Dixons, through PC World and Currys, has bricks-and-mortar retailing alongside its online operations.

Bricks-and-mortar retailers face a dilemma. They have greater overheads but it is not easy for them to separate genuine customers from those who are merely trying before they buy elsewhere.

Research carried out for the Office of Fair Trading shows that bricks-and-mortar retailers tend to be most expensive, followed by those that have both online and offline trading (which includes John Lewis and Harrods). Cheapest of all, in other words cheaper than Dixons, are the online-only retailers.

The OFT research also found, however, that the internet has not lived up to hopes of delivering what economists would think of as perfect competition. There are still surprisingly large price variations, even among competing online retailers. Price comparison sites, for a variety of reasons, have not eliminated such differences. People still go to retailers they trust. The Dixons advertising campaign is cheeky but it hasn't killed off John Lewis. Its weekly figures suggest it has been doing rather well.

From The Sunday Times, November 8 2009