How to spot a bubble
*Last October the International Monetary Fund warned of the risk of another global financial crisis. The Fund sees a 60% rise in global indebtedness in the last ten years and the exposure of banks to illiquid assets as major risks.
*It might seem premature to be talking of the next financial crisis when we have only just marked the tenth anniversary of the last one. But history shows that financial crises are frequent events in the life of market economies. In the twenty years up until 2008 the world witnessed deep financial crises in Russia and Asia, banking crises in Sweden and Finland, Black Monday, a general equity market crash in 1987 and the dotcom collapse of 2001.
*The proximate causes varied - overvalued tech stocks getting their comeuppance in 2001, a reversal of inflows of foreign capital in Asia in 1997 and so on, but the underlying drivers are eerily similar.
*On this subject there’s no better guide than the magisterial “Manias, Panics and Crashes” by Charles Kindelberger, first published in 1978. It is testimony to the enduring relevance of his message that despite Kindelberger’s death in 1996 the book is now in its seventh edition, co-authored by Chicago economist Robert Aliber.
*Kindleberger’s great insight was to show that financial crises, far from being exceptional events, are recurring features of the market system. His work shows that three factors are especially conducive to bubbles.
*First, long periods of economic stability tend to inflate asset prices by making people too confident, too willing to borrow and too oblivious to risk.
*The 15 or so years before 2007 was just such a period, marked by good growth, falling inflation and low interest rates. Volatility and major economic crises were notable by their absence. This stability fostered the impression that credit would stay cheap for ever and that asset prices would keep on rising. There was a similar boom before the US crash of 1929, marked by soaring car production and highway construction and the rapid introduction of electricity and telephones to households. In the late 1920s and early 2000s what appeared to be a new era of technologically-driven prosperity pushed asset prices ever higher.
*Rapid growth in the supply of credit is the second enabler of asset bubbles.
*This, too, is a very old story. Kindelberger shows how the legendary South Sea investment bubble of the early eighteenth century was fuelled by credit from newly established banks. Almost three hundred years later, in the early 2000s, a boom in the availability of mortgage credit for high risk buyers in the US sowed the seeds of the global financial crisis.
*The third feature of a boom that is heading to bust is rapid financial innovation. It played a role in one of the first recorded bubbles, the Dutch tulip mania of 1636 where sellers of bulbs provided buyers with the necessary credit. The failure of innovative and opaque financial structures, such as collateralised debt obligations, played a key role in the financial crisis of 2008. Financial innovation is important because it enables large numbers of less-specialist investors to join in the boom. The legend goes that when shoe shine boys started giving stock tips in the late 1920s seasoned investors sold out. Today one might substitute taxi driver for shoe shine boy.
*Now of course economic stability, a good supply of credit and financial innovation, are highly desirable. Politicians, public and policymakers love strong and stable growth. Credit is the essential lubricant of a market economy. Innovations in finance, from the ATM to peer-to-peer lending and Paypal, make life easier.
*The judgement that regulators need to make is when we have had too much of a good thing. As William McChesney Martin, chairman of the US Federal Reserve in the '50s and '60s, said that it is the job of central bankers to "take away the punch bowl just when the party gets going".
*Getting the timing right is difficult. Regulation and timely changes in policy help reduce the frequency and severity of crises. But to prevent all crises policymakers would need to eliminate the risk taking essential for growth. That dilemma won’t go away, nor will financial crises. They are, as Kindelberger reminds us, a ‘hardy perennial’ of our economic system.
PS: Last week the world’s largest sovereign wealth fund, the Norwegian Government’s Pension Fund, said that it intended to increase its holdings in UK equities and other assets irrespective of the outcome of Brexit negotiations. Over the last two years international investors have been wary of domestically-facing UK equities over concerns about Brexit. By contrast the CEO of the Norwegian fund, Yngve Slyngstad, asserted a robustly long-term view, “With our time horizon, which is 30 years plus, current political discussions do not change our view of the situation.”.
OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 1.1% at 7,102.
Economics and business
* US president Donald Trump postponed an increase in tariffs on Chinese imports until further notice as trade negotiations between the two countries continue
* President Trump’s summit with the North Korean leader Kim Jong Un was cut short without an agreement
* The House of Representatives voted to block Donald Trump’s declaration of a national emergency on the US southern border
* US GDP growth slowed to 2.6% on an annualised basis in the fourth quarter of 2018
* US Federal Reserve chairman Jerome Powell said US inflation will fall even further below the Fed’s 2% goal
* Confidence amongst UK manufacturers fell to its lowest level since at least 2012 according to PMI data
* The UK’s Competition and Markets Authority warned that there could be a crisis of faith in the free-market economy unless consumer protection was strengthened
* The top US consumer protection agency took the unusual step of setting up a task force to look at competition in the technology sector
* The European Commission failed to place Saudi Arabia and four US territories on a money laundering blacklist after virtually unanimous opposition from EU member states
* In a sign of the growing importance of Chinese assets in world markets, index provider MSCI announced an increase in China’s weighting in its emerging markets index, tracked by $1.9tn of funds, which could inject an estimated $125bn into Chinese equities this year
* The US and France called for global tax reform to ensure that tech companies pay reasonable levels of corporate taxes in the countries where they operate
* Marks and Spencer announced it will enter the online grocery market through a joint venture with Ocado
* Israel’s attorney general is to indict prime minister Benjamin Netanyahu on corruption charges, including bribery and fraud, ahead of elections on 9 April
Brexit and European politics
* The FT reports that this week the government will set out plans to boost Britain’s “left behind” towns in a bid to win Labour support for the Brexit deal
* Eurosceptic Conservatives and the Democratic Unionist party are reported to mulling over supporting the PM’s deal if the government obtains “legally binding” concessions on the Irish backstop
* Prominent Eurosceptic Conservative MP Jacob Rees-Mogg seemed to strike a softer tone towards Theresa May’s Brexit deal
* The Labour Party announced support for a second EU referendum
* The FT cited senior Labour MPs as saying there is unlikely to be a Commons majority for a second referendum
* President of the European Commission Jean-Claude Juncker and UK prime minister Theresa May pledged to conclude UK-EU negotiations by 21 March
* Theresa May announced UK Parliament will now vote on her Brexit deal by 12 March
* If this deal is rejected, MPs are to be given a second vote on a no-deal Brexit followed by a third vote on whether to seek a “short, time limited extension” to the 29 March exit date
* Theresa May said any extension could not last longer than the end of June due to upcoming European elections.
* French president Emmanuel Macron has indicated he might not accept a delay unless the UK changes course on its negotiating strategy
* The UK government said tariffs would be imposed on imports of food in the case of a no-deal Brexit to protect British farmers
* The US is seeking greater access to the UK market for US agricultural products in any trade deal
* Opinion polls conducted since the formation of The Independent Group, a breakaway group of eight former Labour and three former Conservative MPs, suggest that it has reduced support for Labour and Lib Dems, and in the process widened the Conservative lead over Labour
* The Financial Conduct Authority has announced a 15-month grace period for compliance with newly published rules in the case of a no-deal Brexit
And finally… US police were called to check on the welfare of an adult male who had been standing “motionless outside” while wearing “no coat in the cold and hugging a pillow”. When they arrived, officers of the state of Minnesota were surprised to find that the figure was actually a life-sized cardboard cutout of local businessman and CEO of MyPillow, Mike Lindell - 2D or not 2D