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
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
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
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.