Beyond Greece and China: Expect a Volatile Passage

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.