New Era


Bubbles do burst
Samuel Brittan, FT, July 22 1999

In an article on May 13 I rejected the rationalisations used to justify the Wall Street surge ('Nonsense on Stilts'). It was accompanied by a chart showing an uncanny resemblance to the upturn leading up to the 1929 crash.

Nothing has happened to make me repent, even though the Dow Jones Average reached a new peak last week - Wall Street indices are 50 per cent higher than when Alan Greenspan, chairman of the US Federal Reserve, first referred to signs of irrational exuberance.

Indeed Stephen King of HSBC has presented a perceptive analysis, not only suggesting that the US stock market boom is indeed a bubble, but venturing a view on how and when it might burst ('Bubble Trouble', HSBC Economics, July 1999).

Strong growth in the money supply, a rising investment share within GDP, a widening current account deficit and a personal sector plunging into deficit are all classic indicators of a bubble. "Virtually all the indicators on the bubbles checklist are flashing red for the US . . . When such bubbles burst soft landings never seem to be within reach."

Mr King argues that the US high-tech breakthrough is far from unprecedented and reminiscent of the breakthroughs of the 1920s. These were genuine enough but became the pretext for excessive equity valuations, fuelling an economic boom.

Some commentators and policymakers are being misled by the absence of inflationary pressures in the goods and services markets. But this is a deceptive sign frequently seen in past bubbles. "Most bubbles develop during a period of above-average growth and below-average inflation. The inflationary pressure is often disguised by declines in global commodity prices or strong exchange rates that suppress inflationary symptoms for a while ... Moreover, during a boom, rapid money supply growth feeds directly into higher output or higher asset prices, and the link between money and inflation is temporarily broken."

According to HSBC Economics, the most likely forces to burst the bubble are a combination of further rises in interest rates - whatever Mr Greenspan may say today - and a falling dollar, both of which are expected in the second half of this year and in the first half of 2000. This should result in a growth slowdown this year and the risk of outright recession by 2001.

Bursting the bubble normally requires a series of official interest rate increases enough to persuade markets that there has been a permanent increase in the discount rate to be applied to future earnings growth and that growth itself is likely to weaken. The recent quarter of a percentage point increase in US base rates, and the proclaimed shift back to a neutral monetary stance, is an example of the kind of rate increase that is shrugged off by the bond markets, which actually rose after the Greenspan move.

Defenders of the "new paradigm" often remark how easily the US - and the world - survived the Wall Street crash of 1987, which took place when earnings yields were no more overstretched than they are today. But HSBC points to one big difference.

Twelve years ago there was little evidence of an overstretched private sector balance sheet and little reason to fear a multiple contraction in private sector spending as a result of a fall in stock prices. Today, a much higher degree of spending is supported by rising asset prices, and an equity correction is likely to have a bigger economic impact.

An academic analysis by the Clare Group of senior economists comes to similar conclusions, if in slightly different language ('Global Stability: Risks and Remedies', by J Flemming, M Posner and J Sargent, National Institute Economic Review, forthcoming July 29). In advanced economies there may be bursts of technological innovation or new market opportunities which cause the upswing of the cycle to be unusually prolonged.

Although these events are of a once-for-all nature, they may be "inappropriately extrapolated"; and "divergence between the expected and the realisable creates problems which the US economy is likely to incur in reverting to a slower and more sustainable growth rate".

Unlike HSBC, the Clare Group do not believe a hard landing is inevitable. But they believe that there is "a non-negligible risk" of it happening and that policymakers would be "foolhardy to fail to take this into account". They fear that a turnround in US growth - say from the present four per cent to minus one per cent - would have a much larger effect on the advanced economies than predicted by conventional models.

The main message of the Clare Group is: be prepared. They are particularly worried that real interest rates might not be able to fall fast enough at a time when inflation is already very low. Indeed, if businessmen were to fear deflation, anticipated real interest rates could rise, even if nominal rates controlled by central banks were to fall to near zero.

One defect of the Clare analysis is that, in characteristic British establishment fashion, it starts to beat the drum much too early for a worldwide fiscal stimulus, in the event of recession, without first examining unconventional policies for boosting monetary growth.

The Japanese recession has produced a whole crop of these, including the monetisation of part of the national debt and aiming - in this exceptional case - for a positive inflation target to influence expectations.

One can agree, however, that at the very least more should be done to explain the action of the built-in fiscal stabilisers, provided for in the fiscal plans of most countries. These allow for temporary increases in deficits, as revenues fall and social expenditures increase in a recession.

Unfortunately, despite the small print of the official economists, nearly all public discussion is in terms of actual crude budget balances that take no account of the business cycle. Governments have not done nearly enough to lay out in advance what they would do in the event of unexpected boom or slump.

It is not enough to point to mainstream forecasts saying that such events are unlikely.

The Clare Group would like to go even further and have a shelf of plans ready for temporary fiscal stimulus going beyond the automatic stabilisers. They do make some valuable points. For instance, cuts in consumer taxes or employee insurance contributions, known to be temporary, are indeed likely to be spent.

Even here, however, the US fiscal system makes such action almost impossible.

In the euro countries, the Fiscal Stability Pact allows deficits to run up to 3 per cent of GDP in a recession. This would be all very well if the normal balance were indeed zero.

But as there has not been this degree of fiscal consolidation - as the European Central Bank incessantly stresses - euro governments would be between a hole and a dark place in the event of an international recession.

But my main complaint about the Clare Group analysis is that, like so many British mainstream economic documents since the second world war, it argues as if a world recession were already upon us, which is then discussed far too much in UK terms.

The immediate picture is one of a seriously overheating US economy, the first signs of a growth take-off in the euro group, and to a lesser extent in Asia, and quickening recovery in the UK.

By all means, be prepared for a reversal. But let us not forget that the seeds of a possible slump lie in over-stimulus and irrational exuberance in the US, and perhaps in other countries as well.

Samuel Brittan now has his own website

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