Last night at Liberty on the Rocks we were talking about the mechanism of collapse -- what might happen were ZIRP and NIRP to continue for ever, were QE to continue to infinity and interest rates never again touching oxygenated air? Is a collapse imminent in that case, or should we expect just a slow and gentle decline into penury as our seed corn is quietly and ineveitable consumed.
The economic system is keeping its head above water, just, but like historian Scott Powell we put this down to what he calls “The Hank Rearden Effect”—the tremendous ability of entrepreneurs, industrialists and inventors to continue producing, in the face of expanding efforts to slow them down –“masking a fundamental decline that now entails a fall.”
It’s the biggest unexamined issue of our age, says Jeff Deist of the Mises Insitute: “Can central banks engineer prosperity, and if so how long?”
Bubbles almost everywhere, and deflationary pressures bubbling under everywhere else. But all bubbles pop – all it takes is a pin. What will be this bubble’s murder weapon, we wonder? Brendan Brown has some suggestions.
There is no ready-made answer in Austrian Business Cycle Theory to the multi-trillion dollar question now looming over the global economy and markets. Is the present virulent asset price inflation disease likely to enter any time soon its final phase of bust and recession? Will this happen even though the American Federal Reserve Bank has flip-flopped on even token steps toward policy normalisation, leading other central banks like the Bank of Japan, ECB, and Bank of England to pursue experiments with negative interest rates and novel forms of mega-balance sheet expansion?
Rate Hikes Usually Come Before Crises
In the small sample-size we have of modern business cycles, especially those featuring severe asset-price inflation like this one, there is no unambiguous example of transition into the crash and recession phase without a prior significant tightening of monetary conditions. The closest is the 1937 crash and subsequent Roosevelt recession. (But the Federal Reserve Bank’s attempt then to normalise monetary conditions via three hikes in reserve requirements through late 1936 and early 1937 — barely three years on from when the monetary base started to explode under the influence of huge gold inflows from Europe — blurs any lessons which might be drawn.)
By contrast, today’s Fed is now past its sixth anniversary of massive monetary-base expansion, and even wilder monetary experimentation has been occurring abroad. (We’re looking at you, Japan – and all you apostles of NIRP) The Yellen Fed has now flip-flopped in its stated programme of “rate lift-off” on any sign that the S&P 500 might be seriously retreating from present highs. Implicitly, today’s monetary experimenters appear to assume that they can at will exercise a series of “Greenspan (or Yellen) puts” to prevent any serious pull-back in market prices until an economic miracle emerges that will justify in fundamental terms the presently inflated asset-prices.
Many investors around the globe — suffering from interest income famine — are inclined to give the Federal Reserve the benefit of the doubt. Few other choices seem available. Asset-price inflation is characterized by the transitory flourishing of speculative stories unchecked by normal rational scepticism which has been numbed by yield desperation. The “success” of The Grand Monetary Experiment has become the biggest speculative story of all.
Strangely, the believers in that story, at least for now, can find superficial solace in early Austrian business-cycle theory. This describes how monetary disequilibrium characterised by market interest rates suppressed well below the (unknown) natural level generates a speculative boom. Eventually a rise of interest rates and tightening credit conditions bring a general bust. So long as interest rates remain around zero, speculators might assume they are safe.
According to the early Austrian cycle theorists, the rise in rates comes about endogenously as households react to the “forced saving” which they unwittingly undertook during the early boom phase (when over-production of capital goods occurs relative to consumer goods). This Austrian narrative explained the great boom in the mid-late 1920s, and the subsequent bust. But it does not apply so well to the present.
Much current “Austrian school” analysis focuses on the irrational behavior in financial markets induced by monetary disequilibrium and the related bouts of malinvestment. In common with the older analysis, the role of “over-lending” is a crucial dynamic of the cycle, albeit that irrationality in non-bank credit markets now tops the list of concerns (in contrast to previous emphasis on banks and fractional-reserve issues). Possible human behaviours in response to the virulent asset-price inflation disease are just too varied for model-based prediction to be successful.
This Time Could Be Different
The sample size of previous asset price inflations is too small to justify forecasts about whether the end phase is likely to be presaged by a tightening of monetary conditions. This time could well be different. A particular attribute of the present asset price inflation disease is the extent to which people are aware of the condition. Many investors looking at the array of high asset prices realise that many of these are far above fundamental value, yet desperation for yield defeats cool rationality.
When we normalise US corporate earnings for the effect of “financial arbitrage,” “abnormally cheap interest costs,” and “accounting gymnastics,” we find price-earnings ratios today which are not far removed from the “irrationally exuberant” stock market peaks of 1929 and 2000. Given that these peaks occurred in eras of rapid productivity growth and prosperity amidst reasonable expectations that the miracle conditions could continue for at least several years more, the gap to “fundamental” value is most likely even larger than then.
In today’s slow growth economy, business decision-makers are understandably cautious. And so ultimately are their shareholders. Long-range projects which potentially pay off in the next recession (which could be very severe due to the extent of prior speculative fever) are widely eschewed, meaning that there is no overall investment boom in the advanced economies – and this despite the insanely cheap cost of capital. Indeed, US business investment has been falling now for three quarters.
We're Living Through a Fragile Boom Period
Bouts of highly leveraged speculative economic activity do take place. and these can burst without any US-led monetary tightening under the influence of glut and related profits disappointment. The highly leveraged investor in shale oil or in emerging market industries hoped to earn mega-riches within a few years, thanks in large part to the fantastically low cost of debt, even if understandably dubious about the possibility of selling out his equity position before the downturn. Leverage brings forward the potential realisation of speculative profit.
Equity investors in general realise that there are these big areas of highly leveraged overinvestment and malinvestment, and that the next recession may well originate from there. Now, many question the sustainability of commercial real estate booms whether in the US or in the emerging market world — alongside several residential hotspots. Overbuilding, rental declines, and vacancies are the catalysts to bust without any rise in rates.
And yes, the possibility of speculative boom and bust exists in some areas of economic activity where high leverage is absent. That occurs where there has been the hyped up speculative narrative alongside booming carry-trade activity — in this case from lower yielding liquid assets into higher yielding illiquid assets — with the income famine-crazed participants underestimating the risks. Unicorns in Silicon Valley, and more generally venture capital funds, may fit this description. These often have highly leveraged twins in private equity.
Historically, monetary tightening has been a fatal blow to these carry-trade booms that thrive in the early and middle phases of asset price inflation. There can be a long lag however between the blow and the bust, which might occur well beyond the tightening having given way to super-ease. It is possible that any today’s carry-trade booms will burst — whether in credit, illiquidity, or ultimately equity and real estate – even without any further tightening episode beyond those very slight Federal Reserve manoeuvres of 2013–15. What looks like risk-free profits cannot remain that way forever, and bailouts can only postpone the inevitable.
Future historians might blame the bust on those manoeuvres. At least we present-day commentators who might disagree can write, like Josephus, that we saw these events with our own eyes.
Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International. He is also an associated scholar of the Mises Institute, and author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution.
This post first appeared at the Mises Daily.