Something’s got to give:
Markets are too dependent on unsustainable government stimulus
The effect of free money is remarkable. A year ago investors were
panicking and there was talk of another Depression. Now the MSCI world
index of global share prices is more than 70 percent higher than its low
in March, 2009.
That’s largely thanks to interest rates of 1 percent or less in
America, Japan, Britain and the euro zone, which have persuaded
investors to take their money out of cash and to buy risky assets.
all the panic last year, asset values never quite reached the lows that
marked other bear-market bottoms, and now the rally has made several
markets look pricey again.
In the American housing market, where the crisis started, homes are
priced at around fair value on the basis of rental yields, but they are
overvalued by almost 30 percent in Britain and by 50 percent in
Australia, Hong Kong and Spain.
Stockmarkets are still shy of their record peaks in most countries.
The American market is around 25 percent below the level it reached in
2007. But it is still nearly 50 percent overvalued on the best long-term
measure, which adjusts profits to allow for the economic cycle, and is
on a par with two of the four great valuation peaks in the 20th century,
in 1901 and 1966.
Central banks see these market rallies as a welcome side- effect of
their policies. In 2008, falling markets caused a vicious circle of debt
defaults and fire sales by investors, pushing asset prices down even
The market rebound was necessary to stabilise economies last year,
but now there is a danger that bubbles are being created.
Forever blowing bubbles?
Aside from high asset valuations, the two classic symptoms of a
bubble are rapid growth in private-sector credit and an outbreak of
public enthusiasm for particular assets.
There’s no sign of either of those. But the longer the world keeps
its interest rates close to zero, the greater the danger that bubbles
will appear-most likely in emerging markets, where growth keeps
investors optimistic and currency pegs import loose monetary policy, and
Central banks have a range of tools they can use to discourage the
growth of bubbles. Forcing banks to adopt higher capital ratios may curb
As Ben Bernanke, chairman of the Federal Reserve, argued this week,
the rise in American house prices could have been limited through better
regulation of the banks. The most powerful tool, of course, is the
But central banks are wary of using it to pop bubbles because it
risks crushing growth as well. And, with the world economy in its
current fragile state, they are rightly unwilling to jack up interest
rates now. But even if governments judge that the risks posed by raising
rates now outweighs that of keeping them low, investors still have
plenty of reasons to worry. The problem for them is not just that
valuations look high by historic standards. It is also that the current
combination of high asset prices, low interest rates and massive fiscal
deficits is unsustainable.
Interest rates will stay low only if growth remains slow. But if
economies grow slowly, then profits will not rise fast enough to justify
current share prices and incomes will not rise far enough to justify the
prevailing level of house prices. If, on the other hand, the markets are
right about the prospects for economic growth, and the current recovery
is sustained, then governments will react by cutting off the supply of
cheap money later this year.
It doesn’t add up
But the more immediate risks may be posed by fiscal policy. Many
governments responded to the crisis by, in effect, taking the debt
burden off the private sector’s balance-sheets and putting it on their
own. This caused a huge gap to open up in government finances.
Deficits in America and Britain, for instance, stand at more than 10
percent of GDP. Most developed-country governments have managed to
finance these deficits fairly easily so far. In the early stages of the
crisis, investors were happy to opt for the safety of government bonds.
Then central banks resorted to quantitative easing (QE), a polite
term for the creation of money.
The Bank of England, for example, has bought the equivalent of one
year’s entire fiscal deficit.
There are signs, however, that private-sector investors’ appetite for
government debt may be just about sated, as they contemplate the vast
amount of government bonds that are due to be issued this year and the
ending of QE programmes. The yields on ten-year Treasury bonds and
British gilts have both risen by more than half a percentage point since
late November. Investors (along with this newspaper) would like to see
governments unveil clear plans for reducing those deficits over the
medium term, with the emphasis on spending cuts rather than tax
But politicians are nervous about the likely reaction of electorates,
not to mention the short-term economic impact of fiscal tightening, and
are proving reluctant to specify where the cuts will be made.
Markets have already tested the ability of the weakest governments to
bear the burden of their debt. Dubai had to turn to its wealthy
neighbour, Abu Dhabi, for help. In the euro zone, doubts have been
raised about the willingness of Greece to push through the required
Electorates are likely to chafe at the cost of bringing down
government deficits, especially if the main result is to repay foreign
That will lead to currency crises and cross-border disputes like the
current spat between Iceland, Britain and the Netherlands over the bill
for compensating depositors in Icelandic banks. Such disputes will lead
to further outbreaks of market volatility.
Investors tempted to take comfort from the fact that asset prices are
still below their peaks would do well to remember that they may yet fall
back a very long way. The Japanese stock market still trades at a
quarter of the high it reached 20 years ago.
The NASDAQ trades at half the level it reached during dotcom mania.
Today the prices of many assets are being held up by unsustainable
fiscal and monetary stimulus. Something has to give.
From ‘The Economist’ print edition