What is behind the world financial bubble?
And how will it end?
Everybody is talking about how shares, especially American ones, are overvalued, and that the bubble is about to burst. That is not the only case of inflated values - Bitcoin and gold are on a tear. The Economist also recently warned about high levels of government debt in some developed countries (America, Britain and France in particular - but Italy and Japan get a mention too), concluding that this is likely to lead to inflation - which suggests that government bonds are overvalued too. Should these bubbles burst then there could be major repercussions for the world economy.
But markets aren’t supposed to be like this. If people think assets are overvalued then this should be reflected in the price. The bubble should have burst yesterday. And yet each dip is soon followed by a rally to newer heights. We need to try and understand this to assess just how much danger the financial system is in. Is this a rerun of 1999, when the tech bubble was in full swing - where the bubble bursting led to dislocation but not catastrophe? Or 2006, before bubbly financial markets fell apart slowly, in 2007-08, and then suddenly in 2008-09 - an episode from which the world still hasn’t fully recovered, in some eyes. Or is this 1968? A boom was followed by a long period of stagflation which required brutal monetary policy and a sharp recession to sort out.
There are two ways to think about the value of financial assets. One can be called “fair value”. This is an estimate of the future rewards that will accrue from holding it - income and ultimate capital value - converted to present value using a discount rate. This is clearest for bonds, where both these income and eventual capital return are defined - though you still need to form judgements about the discount rate and any credit risk. But what of things like Bitcoin that have no intrinsic value? The idea with these is that you trade: buy cheap and sell dear. Ultimately this works by simple supply and demand. If a lot of people are buying and few selling, then the price goes up. Expectations about the future of supply and demand create what I will call “speculative value”. This value is based on the expectation of short-term returns and fear of missing out; where values go next week matters more than any long term view.
What is clear is that many assets currently are being driven by speculative value. Bitcoin and Gold are pretty much entirely speculative; there is a large speculative component to American shares; even bonds seem to be affected by speculative principles, which infects assessments of the discount rate and credit risk. You may hear talk of moves in share and bond prices reported in terms of changes to fair value. Thus markets may be said to be reacting badly to the prospect of tariffs - or improved prospects for Artificial Intelligence. But this commentary is itself speculative - journalistic filler without any hard evidence behind it. It is surprising how even respectable journals like the Financial Times and The Economist indulge in this sort of thing. In fact if share values fall sharply it is almost always because there is some distressed selling going on, as investors face margin calls or debt repayments, while rises might simply be investors “buying the dip”. Valuation bubbles may be described as irrational exuberance, but people are making profits, and what is irrational about that? Clearly there is a huge appetite for assets from speculative investors. Let’s try to understand this in terms of macroeconomics.
One red herring is that it is driven by excess savings seeking a home. In standard economics any excess of supply over demand is referred to as savings, and in equilibrium this equals investment (looking at the world as a whole - it’s a bit more complicated when looking at countries in isolation). Investment in this sense is paying people to do things like build data centres, not buying securities on the secondary market, or leaving it in the bank account. Not much of the current boom in financial investments meets this description. Some of the funds being pumped into shares effectively gets spent on building data centres for AI. The financing of government budget deficits also counts as real investment as well as fuelling consumption. But most of the money is simply going round in circles. If there is a disequilibrium between savings and investment, then the usual result is a recession as the economy readjusts itself to a new equilibrium with a smaller amount of savings. There is no sign of a recession currently, and so no overall surplus of savings.
But there does seem to be a surplus of liquidity - spending power available to people and businesses. In macroeconomic terms this is regarded as a monetary policy. Alas this is the weakest part of standard macroeconomic models - though not without reason. Economists understand that monetary conditions can be loose or tight, and that this affects economic conditions, such as aggregate incomes or inflation. They tend to represent this loose or tight property through the state of real interest rates - usually thought of the central bank interest rate less the expected rate of inflation. This is a gross simplification on many levels. The financial system, of which money is a part, is a very complex thing, for which information is incomplete. Liquidity (i.e. the ability to spend at short notice) can be stored over time; how people spend it depends very much on who they are and a host of potential uses. The interaction between the different parts of the financial system, including the various sorts of money, is highly complex and moveable. When the system is under stress, as in 2009, the central bank’s attempts to manage liquidity can be overwhelmed. Meanwhile good, complete data on the financial system is lacking. Some elements are well-known, especially within the regulated banking system, but what counts is the system as a whole. It is no wonder that economists struggle to model it.
This in turn leads to the problem of managing the monetary system. This is often thought to be the responsibility of central banks, though the buck stops with governments. The focus is on inflation and the real economy. If a surplus of liquidity is flowing into the real economy and causing inflation, the central banks are meant to tighten things up by raising interest rates. If the real economy is under stress, then trying to create liquidity is often thought to be a solution. This doesn’t always work. During the covid crisis central banks cut rates and also bought up large quantities of government stock (“quantitative easing”), generating much liquidity. But much of this created liquidity seems to have been stored up and is now being fed back into the market to feed the asset price bubble.
What central banks are loth to do, however, is to intervene to manage asset price bubbles. This is politically unpopular, and there are always questions as to whether the bubble is really a bubble. Asset price inflation is a very different thing to rises in the prices of consumer goods and labour. So, in the midst of this roaring asset price boom, fuelled by surplus liquidity, central banks are actually cutting interest rates. To be fair they are also selling a lot of the government stock bought up during quantitative easing, which tightens liquidity - but they are under pressure to halt this.
How much danger are we in? If asset prices start to fall, this could set off a vicious circle. There could be a lot of distress selling as people try to repay money borrowed to finance share purchases, or face margin calls on derivatives. Defaults could cause financial institutions to fail. This could threaten the banking system, which controls the payments that make the world go round. This is essentially what happened in the great financial crisis of 2007-09, which caused a huge recession, and threatened worse. The system feels a lot safer now, following reforms made after the crash - though there is pressure to ease regulation to support “growth”. However the asset price bubble appears to be much bigger this time. Losses in value could cause people to retrench as their wealth is destroyed, and that would cause a recession more directly.
How does a bubble like this end? Much of the speculation is about people realising the gap between speculative asset values and fair values, and cashing in their investments to park them into something safer (what?). But if the bubble is being driven by excess liquidity, then it is more helpful to look at things that reduce liquidity, so forcing people to liquidate investments. An obvious possibility is if central banks tighten monetary conditions by raising interest rates and selling securities. They are under huge political pressure not to do this, but if inflation rears its ugly head, then they will be forced to do so. This could come about if the bubble itself fuels additional consumption as people feel wealthier - also if governments continue to ride the bubble by running large budget deficits while financing government debt is easy. However currently these wealth effects are being offset by economic uncertainty arising from erratic financial policy.
A further cause of reduced liquidity is a crisis within the banking system itself. This could be triggered by bankruptcies among large borrowers, and then amongst financial institutions themselves. That could be triggered by central bank tightening, but it could also happen independently if there is a panic amongst a particular group of investors. This could be triggered by poor financial results (e.g. from big investors in AI) or fraud (in crypto assets perhaps). Some form of business failure is all too likely in the AI sector, as massive amounts are being invested in real assets and development without a clear business model for how these costs are to be recouped. However many of the largest investors (the tech giants) are well-capitalised with deep pocket, and so don’t look especially risky from that point of view. There are doubtless others on the fringes, though. If there is trouble, it is most likely to start outside the regulated banking system, in the shadow banking system. This includes hedge funds, private equity and debt funds, and crypto stable-coins. This poses less immediate risk to the world at large, but would infect regulated banks in due course.
What does this amount to? I’m talking myself into the thought that a major financial crisis is not imminent. There may be corrections for some asset classes, especially shares, but this is likely to prove a little local difficulty. High levels of liquidity ensure a degree of resilience. I suspect things will develop more like the great financial crisis of 2007-2009: slowly and then suddenly. The first signs of trouble arose in early 2007, when asset prices stopped rising, and sub-prime lending in the US got into trouble. It then rumbled on slowly until the Lehman bankruptcy in late 2008, and developed very rapidly from there. But rather than a 2009-style meltdown, we might be met with a run of 1970s-style inflation, requiring a 1980s-style recession to bring order back.
It’s hard to keep track of things as a retired person in East Sussex but I will be keeping an eye on my usual sources.