By John Kemp
LONDON, July 10 Buying ultra-low yielding long-dated government bonds that guarantee losses in the event of even moderate inflation or interest rate rises any time before maturity, or leaving cash on deposit at negative real interest rates, as many households and companies across the advanced industrial economies have done in the last three years, is fundamentally irrational behaviour.
The current extreme preference for safe assets and liquid assets, is no more rational than buying technology stocks at the height of the internet boom in the 1990s, writing negative amortisation mortgages for subprime households in the mid-2000s, or buying oil futures at $140 per barrel in 2008.
Some investors are genuinely trying to insure their portfolios against a renewed downturn in the economy and a return of extreme financial instability. Others are merely jumping on the bandwagon, relying on herding behaviour and momentum to elevate the price of risk assets even further before the market corrects.
Still more are relying on the existence of a "bigger fool" to buy safe assets at an even higher price in future -- in most cases a central bank willing to pay for them as part of a quantitative easing/asset purchase programme.
Each of these strategies is an example of the short-term rational but long-term irrational thinking that drives the inflation of a bubble. They fit perfectly the classic description of bubble behaviour described by George Soros ("The Alchemy of Finance"), Didier Sornette ("Why Stock Markets Crash") and Robert Shiller ("Irrational Exuberance").
The last two decades have witnessed a series of increasingly large and disruptive bubbles in equities, U.S. government bonds, housing finance and commodities. Now it seems that a bubble has formed in fear.
The bubble in fear is an obvious reaction to earlier bubbles in more risky assets. In some ways it might be described as an "anti-bubble." But that concept is already used to describe the abrupt collapse in valuations when a bubble bursts or a flash crash. This is much more enduring. It is better described as a true bubble in fear and excess demand for liquidity.
The point about bubbles is that it can be rational to trade with the flow in the short-term but losses are almost guaranteed in the long-term except for the very few investors who manage to get in early and get out early. Soros and a handful of other legendary investors have perfected the technique; most others will simply lose money.
In the current bubble, investors appear to be significantly overpaying for protection against short-term negative risks (such as another banking crisis or a return to recession) at the risk of substantial losses in the longer term.
There can be genuine reasons to demand safe, liquid assets. But for the strategy to be rational, investors must be able to assess the scale and likely timing of negative risks quite accurately.
For example, there is clearly a non-zero risk of banking failures in the euro zone. Investors might reasonably demand liquidity and German government bonds to protect against it. But the risk may not be as large as some investors fear (the number of actual banking failures since 2008 is still low) and timing is uncertain (investors have been worrying about banking failures for several years already without the risk materialising).
In buying ultra safe and ultra liquid assets, investors are paying an immense price (in terms of lost returns and shouldering bubble risk) to insure their portfolios against the short-term risk of default and recession. Whether this price is worth paying depends crucially on how large and imminent that default and recession risk really is.
Arguably, many investors, businesses and households are exhibiting an irrational demand for liquidity and safety, and aversion to risk, based on a miscalculation about risks -- refusing to accept even a small threat of being suddenly wiped out by default or recession, while accepting a large risk of being gradually wiped out by inflation and the bubble unwinding.
KEYNES' ANIMAL SPIRITS
As usual, the problem was anticipated by John Maynard Keynes -- justifying his claim to be the greatest economist and financial theorist of the 20th century.
Keynes recognised that almost all investment decisions require a leap of faith that is not strictly rational -- a willingness to accept some degree of residual uncertainty that no purely rational calculating machine would tolerate.
In his famous "General Theory", Keynes wrote: "If we speak frankly, we have to admit that our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence" ("The General Theory of Employment, Interest and Money" 1936).
"If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation."
It is the importance of non-rational motivations that explains why Keynes placed so much emphasis on "animal spirits" or the state of investors' and entrepreneurs' expectations. By sapping that willingness to shoulder a degree of incalculable uncertainty, the bubble in fear destroys the vital process by which economies form capital, grow and generate employment.
EUTHANASIA OF THE RENTIER
In responding to a bubble in fear and unwillingness to invest, one option for the authorities is to try to burst the bubble by raising the costs of holding safe, liquid assets, force investors to reconsider their preference for liquidity, and shift into riskier assets.
Keynes was scornful about "investors" who wanted returns without shouldering any risk and uncertainty, and called for the "euthanasia of the rentier" through policies calculated to slash the returns on riskless assets or even make them negative.
Modern central bankers have attempted to put the theory into practice through quantitative easing -- which lowers the prospective returns on safe, liquid assets and is designed to punish savers and investors who insist on continuing to hold them rather than putting their money to work in more productive and riskier ways.
The implicit message from Fed Chairman Ben Bernanke and his colleagues around the world to investors is that the continuing preference for liquidity will come with a hefty price tag; it may insure against short-term default and adverse market movements, but it is guaranteed to lose money in the long term.
Keynes himself, though, was sceptical about whether monetary policy could overcome a bubble in fear and extreme demand for liquidity. It is why he argued that, in some circumstances, the government should step in to commission the investment that firms and households declined to commission themselves.
Because the government can spread risk across the whole of society, its capacity to accept negative outcomes on at least some projects, is far higher than for any single business or individual. It was the government's superior capacity to bear risk -- not any inherent belief in its capacity to make better decisions -- that led Keynes to advocate greater state-led investment when the economy becomes gripped by a bubble of fear.
With or without government intervention, the bubble in fear will eventually unwind. Sharp observers have already begun to mutter darkly about "financial repression." But financial repression is no accident. It is the deliberate objective of a policy designed to curb the demand for liquid assets and force greater willingness to commit to less liquid forms of investment.
Eventually, enough households and businesses will recognise they are overpaying for liquidity.
In the meantime the best way to think about current financial conditions is as a bubble in fear and demand for liquidity, which has continued to inflate even as real economic and financial risks have begun to recede, and must eventually collapse when the usual bubble-generating processes are no longer capable of inflating it further.