September 11, 2018 / 6:59 PM / a month ago

Breakingviews - Chancellor: The mother of all speculative bubbles

LONDON (Reuters Breakingviews) - In 1776, English man of letters Horace Walpole observed a “rage of building everywhere”. At the time, the yield on English government bonds, known as Consols, had fallen sharply and mortgages could be had at 3.5 percent. In the “Wealth of Nations”, published that year, Adam Smith observed that the recent decline in interest had pushed up land prices: “When interest was at ten percent, land was commonly sold for ten or twelve years’ purchase. As the interest rate sunk to six, five and four percent, the purchase of land rose to twenty, five-and-twenty, and thirty years’ purchase.” [i.e. the yield on land fell from 10 percent to 3.3 percent].

A child tries to grab a soap bubble on a sunny autumn evening in Berlin, October 22, 2011. REUTERS/Thomas Peter

Smith explains why: “the ordinary price of land ... depends everywhere upon the ordinary market rate of interest.” That’s because the interest rate discounts and places a capital value on future income. All the great speculative bubbles in the past – from the tulip mania of the 1630s through to the global credit bonanza of the last decade, have occurred at times when interest rates were abnormally low.

The trouble is that after the Lehman Brothers collapse, central bankers refused to accept this fact. The position of Ben Bernanke’s Federal Reserve was that the real-estate bubble was caused by lax regulation rather than his predecessor Alan Greenspan’s easy money. If this were true, then taking short-term rates down to their lowest level in history – to zero in the United States and negative in Europe and Japan – was sensible. But if Smith was correct, then monetary policy in the wake of Lehman’s bust was a case of the hair of the dog.

In the last decade the world has witnessed bubbles galore: in industrial commodities and rare earths; in U.S. farmland and Chinese garlic bulbs; in fine or not-so-fine art, depending on your taste; in vintage cars and fancy handbags; in “super-city” properties from London to Hong Kong, and across China’s tier-one cities; in long-dated government bonds; in listed and unlisted technology stocks; and in the broader American stock market.

Fed officials notoriously failed to spot the real-estate bubble until after it burst. That’s because the current generation of monetary policymakers were schooled in the belief that bubbles didn’t exist. The experience of the subprime crisis apparently left them not much wiser. In April 2016, Fed Chair Janet Yellen, flanked by former Fed chiefs Paul Volcker, Greenspan and Bernanke, denied that the United States was a “bubble economy”. A bubble market, said Yellen, was one that is “clearly overvalued” and marked by strong credit growth. 

Yet at the time U.S. stocks were very expensive compared to historic levels. They are currently more overpriced on dependable valuation measures, such as total market value to GDP and on a replacement cost basis (Tobin’s Q), than at any time save for the 2000 dot-com bubble. By the end of the first quarter, U.S. non-financial stocks were 85 percent overvalued on a replacement cost basis, according to economist Andrew Smithers. American corporations have also been borrowing like there is no tomorrow.

A second technology bubble is evident in the nosebleed valuations of tech firms such as Tesla. In August, the market value of Elon Musk’s firm overtook BMW’s even though the profitable Bavarian luxury carmaker produced 30 times as many cars last year as the loss-making Tesla, whose shares have since declined. Seven of the world’s 10 most valuable companies are tech stocks, headed by the trillion-dollar Apple. Away from public markets, profitless unicorns, such as the taxi-hailing firm Uber, sport multibillion-dollar valuations. With so much dumb money about, one of Silicon Valley’s new mantras is “spray and pray”.

Consider what history will surely record as one of the most absurd speculative manias of all time: the cryptocurrency bubble. Bitcoin is pure digital fairy dust. Last year the price of the leading cryptocurrency soared nearly 20-fold, peaking at over $19,000. It’s worth around $6,250 today. The boom brought forth many imitators, including ethereum and dogecoin. Bitcoin even has its own offshoots or forks, as they are called, bitcoin gold and bitcoin cash.

At a time when central banks with their negative rates and bloated balance sheets have undermined confidence in traditional money, it’s not surprising that people should look for alternatives. But these new “currencies” couldn’t be used to buy much in the way of goods or services, or to pay taxes. Bitcoin’s technology is far too slow and energy-consuming for such practical purposes. Like the California gold prospector’s storied tin of rancid sardines, bitcoin is good only for trading. 

This collection of bubbles has pushed U.S. household net worth to a record $100 trillion, the Fed reported in June. As a share of GDP, Americans are now richer than they were at the peak of the dot-com bubble and the real-estate bubble, according to the Fed. But this is not real wealth derived from savings and investment, both of which have languished in recent years. It is merely the illusion of wealth.

Former Treasury Secretary Larry Summers once observed the American economy only expands when bubbles are inflating. Both U.S. corporate profits and GDP growth are responding to changes in household net worth. It should be the other way around. Yellen was wrong. The United States is a “bubble economy”, no sounder in its fundamentals than the one which collapsed in the subprime debacle.

Since the interest rate discounts future cash flows, ultralow rates have had an outsized impact on investments whose income lies far out in the future, whether through technology companies or 100-year Austrian bonds (sold in September 2017 for a yield of just 2.1 percent). The crypto carnival could only have occurred at a time when interest rates globally were hovering close to zero.

Adam Smith would have understood this well enough. No bubble lasts forever. The main justification for the elevated level of the S&P 500 Index is that long-term interest rates remain low. But the relationship between bond and equity yields isn’t stable over time. If the Fed keeps on tightening, or if inflation breaks out and bondholders take fright, this latest and perhaps greatest of bubbles will also come to burst.

Breakingviews

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