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Beyond Greece and China: Expect a Volatile Passage

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The economic and financial crisis that hit Greece this summer was at least five years in the making and reflected the entrenched fiscal profligacy of successive Greek governments as well as a fundamental flaw in the euro project, which imposed common monetary policy on its members while leaving them the freedom to run up budget deficits.

Yet it is also no coincidence that the Greek crisis entered an acute phase just as the U.S. Federal Reserve started to talk about raising its interest rates. The current Greek debacle is an extension of the euro-zone debt crisis, which hit in 2010 and was stemmed by massive infusions of liquidity from the European Central Bank in 2013–14. Now, money is getting tighter around the world and the euro-zone debt crisis has raised its ugly head. But the first bubble to pop was the oil market, which happened exactly a year ago, soon after the Fed stopped adding liquidity to the financial system through its quantitative easing program.

False Hopes

Late last year, after world crude oil prices nearly halved from July to December, Goldman Sachs estimated that cheaper oil will give U.S. consumers an equivalent of a $125 billion tax cut. There were even higher estimates of the “oil stimulus” for the U.S. economy, and internationally, some economists expected a boost of $600 billion annually.

We warned, however, that, far from being a new dawn for the global economic recovery, the pricking of the oil bubble could start a dangerous chain reaction in other overvalued asset prices. At first, it could trigger a worsening of other speculative excesses and then lead to the deflation of other overinflated markets. In other words, the oil bubble could become the first in a series of damaging implosions.

Not surprisingly, over the past year financial markets in some major oil importing countries have benefited from lower oil prices, staging spectacular rallies. Tokyo stocks, which have been dead in the water for decades, suddenly came to life, with the Nikkei 225 index gaining around 50%. That paled in comparison to the Shanghai stock exchange, where the Composite index went from around 2,000 to 5,000.

A remarkable — and not highly publicized — bubble has been inflated in German government bonds, or Bunds. The yield on the 10-year Bund fell from over 2% at the start of 2014 to 0.05% this past April. Even now, when it yields 0.9 percent, German bonds seem to be severely overvalued.

Serial Bubbles

Looking back over the two previous financial crashes, in 2000 and 2008, a troubling pattern emerges. In 1997, Pacific Rim Tigers — South Korea, Thailand, Indonesia, Malaysia and others — came down with what was called at the time the Asian flu. Having piled up huge foreign currency debts, those countries suddenly saw their currencies weaken. This put them on the brink of bankruptcy. The crisis spread into Eastern Europe — first, to the Czech Republic and then, a year later, to Russia.

Those crises led to the demise of Long-Term Capital Management, a hedge fund, but otherwise Wall Street continued to boom, in effect feeding on the spreading financial crisis overseas. Despite Alan Greenspan’s warning about “irrational exuberance” in stocks, the NASDAQ Composite index took off, gaining 3,000 points between the start of 1999 and its March 2000 peak just above 5,000. Then, even as the dot-com bubble finally burst, the Dow Jones Industrial Average continued to trade at high levels through most of 2000, before plunging in its turn.

A similar pattern was repeated in 2007–08. In the run-up to the subprime mortgage crisis, the three most overvalued bubbles were in house prices, oil and stocks. The Dow reached its peak in September 2007; as stock prices started to go down at an accelerated pace, house prices fell as well. However, oil prices continued to rise, reaching their peak not long before the September 2008 demise of Lehman Brothers. It was then that oil set its absolute record of $147 per barrel.

Monetarists warn against excessive monetary ease, claiming that if money supply expands faster than economic growth, money will begin to lose its value. Major central banks around the world, led by the Fed, have not been paying much attention to monetarist prescriptions while pumping liquidity into the global financial system over the past seven years. However, the relationship of supply and demand remains fundamental: When supply of a widget increases, its price or value falls—and money is no exception.

Creative Destruction

In the early post-World War II decades, excess money supply was being mopped up by inflation, as more money was chasing a set quantity of consumer goods and its value was being gradually degraded. In today’s economy, a variety of factors — which include uneven wage distribution and slow wage growth for the middle class, the IT revolution, the rise of China and other low-cost producers and intensified competition — have kept consumer price inflation to a minimum (as measured by the average consumer basket) and even triggered deflationary pressures in some economies.

This encouraged central banks to keep printing more and more money. There is no question that they have created an excessive supply of money — more than can be productively invested. Over the past seven years, U.S. government debt held by the public — a proxy for U.S. dollar cash around the world — increased by a whopping $8 trillion, to $13 trillion, as of the first quarter of 2015.

About $5 trillion of that cash is found on the balance sheets of U.S. companies, which suggests that they have a lot more money that they can put to productive use. Not surprisingly, money is free and thrift gets no reward. Banks offer time deposits at “up to 0.3% APR,” which sounds like a mockery of the saver.

Actually, in today’s market conditions thrift is being punished: Some governments in Europe and Japan, as well as some state-backed companies such as Airbus, have been issuing bonds carrying a negative coupon — meaning that creditors pay such borrowers for the privilege of giving them their money.

What happens to all this liquidity? It piles into assets that are perceived as undervalued, where investors can still make a return; for example, into the Tokyo stock market, which has been treading water for years. Since there is so much liquidity seeking returns, investment gains become a self-fulfilling prophecy for astute early investors, but as a result of this a speculative bubble is created.

Economics studies ways to allocate scarce resources most efficiently in order to satisfy unlimited human needs. The paradox is that when a resource becomes unlimited, efficiency and market discipline go out the window. To put it bluntly, an unlimited resource in the end becomes allocated stupidly and leads to huge losses.

The 45–50% reduction in the global price for oil over the past year destroyed around $1.5 trillion worth of global GDP. True, oil consumers got more money in their pockets and they spent more on other goods and services, but there were also layoffs across the entire energy sector and cancellations of various investment projects. The recent popping of the speculative bubble in China destroyed $4 trillion worth of wealth.

The Fed increased its balance sheet by over $3 trillion, to $4.5 trillion, as it pursued extreme monetary ease since the advent of the Great Recession in 2008. The central bank claims that it will eventually sell the securities it now holds back to financial institutions, thus pulling all the liquidity it created out of circulation. But bubbles popping around the world suggest that it may not need to do so: Markets are already doing the job of destroying extra liquidity much quicker and much more efficiently.

Bubbles and Pyramids

There is nothing new about speculative bubbles. The first one occurred in the Netherlands in the 1630s and was known as the Tulip Mania. The Dutch were caught up in trading rare tulip bulbs, which at the peak of the frenzy fetched an equivalent of the cost of a house.

Just like our current bubbles, the Tulip Mania was the result of excess liquidity. In the mid-1550s, Spain began mining vast quantities of gold in its South American possessions, bringing it to Europe and triggering a bout of inflation. The Dutch, along with the English, got a lion’s share of South American gold because they exported their textiles, armaments and other manufactured goods to the Spanish market.

Bubbles work on the same principle as Ponzi schemes. Early investors rake in huge profits, fools rush in, the smart money gets out in time and the rest end up holding the bag.

Somebody once said that pyramid schemes are an efficient market mechanism that plays an important role in the economy: They separate fools from excess financial resources that they have no idea what to do with.

What is different in the case of financial pyramids is that before they have a chance to spread too widely and then implode, governments step in to put an end to the party and cart the organizers to jail. When financial bubbles occur, the authorities, on the contrary, often do their best to keep them from popping.

The Chinese government, for example, intervened to stem the decline in share prices and as of mid-July it appeared to be gaining an upper hand and stemming the panic.

One of two things is now likely to occur. With the government providing an effective “Chinese put” — or a floor under losses — Chinese investors might come back to the stock market in droves, pushing Chinese share prices to new unsustainable heights and setting the market up for an even more disastrous selloff some time in the future.

Another possibility is that the government fails and the bubble deflates for real — which can definitely happen given China’s economic slowdown and political concerns.

This will have repercussions for speculative bubbles in other markets. For example, Chinese investors may withdraw funds from the overvalued New York real estate market to make up for the losses they suffered at home. Alternatively, they may become disillusioned with their domestic markets and, legally or not, invest even more money into U.S. assets, resulting in even higher prices in New York City or producing another rally in the U.S. bull market.

In any case, the serial popping of financial bubbles has started: Since mid-2014, we have seen the oil bubble, the Chinese stock market bubble and the Greek/euro-zone debt bubble pop. Others will soon follow.