FYI | Nov 19 2009
By Chris Shaw
Recently former US Federal Reserve governor Frederic Mishkin wrote an article arguing not all asset bubbles are bad for the economy, which as Michael Rosborough of CIBC World Markets notes is at least a partial acceptance that one current objective of policy in at least some economies is to create asset bubbles to use as a policy tool.
The theory is one of pushing up the prices of some assets so as to allow for a return of investor confidence, which is an important element of an economic recovery. The key for Rosborough is there are two types of bubbles – the benign sort, where asset values increase but the financial system doesn’t over-leverage itself in the process, and the more toxic type recently experienced around much of the world.
The toxic type bubble sees the financial sector become highly geared until the eventual deleveraging process after the bubble bursts sets up a negative loop that impacts on both asset prices and the broader economy. In other words, the first is a bubble in equity prices, the second a bubble in credit and property markets where higher levels of gearing are the norm.
If the global financial crisis is an example of the latter the bursting of the technology stock bubble in 2000 is an example of the former, Mishkin noting in his article the end of this bubble actually had a relatively benign impact on the global economy.
Assuming the outcome of policies put in place in the US and UK is a benign bubble, there is little to fear according to Mishkin, but as Rosborough points out there is also the matter of recent asset price gains in emerging markets and the possibility a “short US dollar” bubble is forming. These have potentially more significant implications as it means the bubbles could take something more like the latter form of toxic bubble.
Looking at the emerging markets the so-called BRIC nations of Brazil, Russia, India and China have seen their respective equity markets rise by 70%-125% this year, putting them back at levels equal to where they were trading before the global financial crisis began.
Factor in the weak greenback over the past year or so and in US dollar terms German, Canadian and Australian equity markets have closely mimicked the MSCI Emerging Markets Local Currency Equity Index and are now back to near early 2007 levels, while the US and UK markets, which represents the economies where quantitative easing and stimulatory fiscal policies have dominated, continue to struggle.
As Rosborough points out, part of this performance can be explained by the fact equity market gains rather than currency appreciation acts as a release valve for capital flows in emerging markets in particular, whereas in developed markets such flows appear as both asset price and currency gains.
In Rosborough’s view the important question is where to from now, especially given the global economy at present is one of depressed demand from major current account debtor nations, while the terms of trade are moving sharply in favour of the US given the weakness in its currency.
One possible outcome is the stimulus required to offset the demand shock of the downturn may mean a positive wealth shock in the less impaired nations, one that would see them invest and consume more in their domestic economies and so counter the lack of any demand pull from other nations.
But as Rosborough suggests, such an outcome would still be sub-optimal policy as the history of management by bubbles has not been so pretty, as evidenced by Japan in the 1990s when it endured not only an equity bubble but bubbles in credit and real estate markets as well.
The big issue will be what happens when fiscal and monetary policy again gets tightened as this will change market conditions, but as Rosborough points out this appears some time off in a number of economies and the US in particular. As a result, he expects emerging market equities and markets in the likes of Canada, Germany and Australia should continue to move higher, at least in US dollar terms.
