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Economics Weekly

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Financial markets: forever blowing bubbles?

Tue, Sep 16 2008, 06:15 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Are some institutions too big to fail?
The bail out of Fannie Mae and Freddie Mac is ‘...one of the largest financial interventions not only in US history but in any country’s history. But the costs to the government is manageable’ says an analyst at S&P. The liabilities of the two GSEs come to $5.4 trillion and will be added to the US government’s gross financial liabilities, though it will not impact its credit ratings say many (though costs associated with insuring against US government debt default - CDS spreads - reached some 20 basis points on the news, or $20,000 for every $10m of debt). Some $200bn has been set aside by the US authorities for potential losses on the assets of the agencies, but the cost is more likely to be $325bn according to S&P, some 2.3% of US gdp. This highlights the ever rising costs of the financial bubbles that have plagued the world economy in the last 10 years, in part related to US monetary policy in our view but also global monetary trends. So many financial firms have become ‘too big to fail’ one has to wonder where this process of adding private sector debt to the public sector will stop. What will ultimately prevent it, of course, is a situation in which the public sector also becomes unable to take on any more debt.

A decade of financial market bubbles
Although this should be of major concern, it is not the central issue we concentrate on here, rather we focus on what economic and financial market trends may have helped to initiate the conditions that can give rise to such huge risk taking. But we believe that in the 1990’s - 2000’s the reaction of central banks to financial market crises has contributed to a sense that asset prices cannot be allowed to fall too sharply, or key firms to fail. This has resulted in an asymmetric policy responses (i.e. doing nothing to prevent booms / profit peaks but protecting downturns by lowering interest rates to prevent failures and mitigate losses) that has encouraged ever greater risk taking by the private sector as it senses that the public sector will step in should things worsen too much.

This has helped lead to a decade in which financial markets losses and crashes are seemingly becoming more frequent and getting bigger. Chart a clearly shows that in the decade to 2008, there have been about 4 financial booms and busts. How has the economic and financial market environment contributed to this?

Economic and financial market developments encouraged bubbles by increasing liquidity and lowering the cost of borrowing…
Efforts to control price and wage inflation finally paid off in a sustained and significant manner from around the mid 1990 onwards, as shown in chart b. This fall in global price inflation led to cuts in nominal interest rates and a subsequent fall in ‘real’ or inflation adjusted interest rates see chart c. This massive fall in the real cost of capital encouraged a burst of borrowing, and spending, by households and individuals. In turn, this contributed to a boom in economic growth and a sharp rise in money supply, see chart d. Indeed, real interest rates

were negative between 2003 and 2005, see chart c again. (Some of the current global imbalances, excessive budget and trade deficits in the US and UK and excessive surpluses in the Japan and large emerging markets, developed during this period of fast growth and strong borrowing, the latter especially in the advanced economies). The consequences of fast economic growth, low interest rates and plentiful liquidity is best exemplified in the monetary data, chart d, which shows how rapidly its growth expanded.

…but this has resulted in greater risk taking and more frequent boom / busts in financial markets in the period
This burst of liquidity also showed up in asset price inflation, see chart e, and in the rapid expansion of credit and derivatives instruments that were designed to boost returns at a time when low interest rates had lowered them sharply. This increased risk taking - and the increased leverage that it implied - is highlighted in charts f and g. So there were regular booms and busts in the last decade. In the latest episode, the explosive growth in derivatives was predicated on a low inflation, low interest rate environment persisting far into the future. Once this changed, the huge bets were exposed as the underlying assets on which they were based fell sharply in value. Of course, what triggered the crash was a rise in inflation and hence a subsequent rise in nominal interest rates and rising defaults on mortgage securities as the housing bubble burst.

…and preventing it in the future will be hard to do
But knowing what may have contributed to this decade of financial market bubbles is not the same as being able to avoid them in the future. The simple answer would be for central banks not to rescue firms by cutting rates too much and to raise official rates to prevent bubbles from developing or taking other measures to limit excessive risk taking. But this is clearly harder to achieve than to suggest. After all, as chart c shows, real interest rates are still very low, yet many are calling for further cuts in nominal interest rates in order to prevent further banking problems (that are undoubtedly serious) that are impacting the rest of the economy. But the risk is that taking action to help them, just means the problem becomes bigger the next time. The end game, of course, is that there will come a time when the public sector is unable to help because it is too highly indebted and the biggest crash of all will then occur. We hope not, but perhaps that is what it may take to change attitudes to risk taking.

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Published on  Tue, Sep 16 2008, 06:28 GMT