The Bubble Cycle is Replacing the Business Cycle
Maybe there's a New Economy after all
by Eric Janszen
Note: this article originally appeared on the AlwaysOn Network, March 13, 2005.
Let's put to rest the myth that the Fed is blind to asset bubbles and never intentionally acts to prick them. The truth can be obtained by anyone with an internet browser and a few hours on their hands to read the voluminous Fed Open Market Committee (FOMC) meeting minutes. In the FOMC meeting minutes from March 22, 1994 (pdf), Greenspan says (my emphasis in italics):"When we moved on February 4th, I think our expectation was that we would prick the bubble in the equity markets. What in fact occurred is that, as evidence of the dramatic shift in the economic outlook began to emerge after we moved and long-term rates began to move up, we were also clearly getting a major upward increase in expectations of corporate earnings. While the stock market went down after our actions on February 4th, it has gone down really quite marginally on net over this period. So what has occurred is that while this capital gains bubble in all financial assets had to come down, instead of the decline being concentrated in the stock area, it shifted over into the bond area. But the effects are the same. These are major capital losses, which have required very dramatic changes in the actions and activities on the part of individuals and institutions."To try to restore some degree of confidence in "the System," as Greenspan calls it, the Fed injected liquidity in 1994 that restored function to a dysfunctional banking system and rescued the bond market. But what cures one bubble sows the seeds of new ones. As Martin Mayer said in his book The Fed: "The truth is that liquidity, the only significant weapon remaining in the central bank's arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there."
"So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position—having done that and in a sense succeeded perhaps more than we had intended—to try to restore some degree of confidence in the System."
The 1994 liquidity injection kicked off the largest and longest period of real estate appreciation in US history and launched the late 1990s stock market bubble in the bargain. Five years later, in June 1999, the Fed appears to have moved to prick the new stock market bubble in the same purposeful manner as in 1994, except you won't find the same explicit discussion about pricking bubbles in the minutes of the June 30 FOMC meeting notes. The only reference to asset bubbles comes from the President of the Federal Reserve Banks of Boston, Cathy E. Minehan, during the previous month's meeting (emphasis added):
"We recently held a meeting of the Bank's Academic Advisory Council which, as you all know, includes two or three Nobel Prize winners and people from Harvard, MIT, Yale, and so forth. The discussion focused on issues related to productivity growth, labor market tightness, and asset market bubbles. The group was lively, to say the least. But some consensus was reached on the need for action that might take the wind out of asset markets, even in the absence of tighter monetary policy, perhaps through increased margin requirements or increased supervisory oversight on credit extended, particularly in the day trading operations."
She also commented on "excesses and imbalances" in the "stock markets, real estate markets, corporate and personal debt." If there was concern around the FOMC in 1999 about real estate excesses, you have to wonder what the FOMC thinks today. The median home price in California is up 123 percent since then. That's close to the median home price increase for the US in the previous 20 years, from 1980 to 1999.
We won't know for a while what committee members think because the full minutes of FOMC meetings are released after a five-year lag, but two things appear to have changed since 1994. First, there has been an apparent shift in the policy of talking about bubbles openly in committee meetings. Second, the Fed now appears to wait until the latest bubble has become considerably more egregious than the previous one. But otherwise the responses and results are the same.
Nine months after the Fed began to withdraw liquidity from the markets (starting in June 1999), the bubble popped in March 2000. The Fed then beat the previous post-bubble Fed rate cut record of 4% in 14 months, from 6% to 2%, that followed the 1929 crash. Between January 2001 and June 2003, the Fed flushed the System with liquidity once again as the Fed Funds Rate target was cut from 6.5% to 1%.
After more than four years of post stock market bubble collapse reflation, with short term interest rates kept below the rate of inflation, it appears that liquidity once again did "not necessarily go where you want it to go," resulting in the creation of bubbles in several asset classes. Unique to this bubble period, several asset classes that have historically been counter-cyclical, such as bonds and equities, are all rising in tandem. Now we have:
A Housing Bubble
A Bond Bubble
A Private Equity Bubble
A Hedge Fund Bubble
A Commodities Bubble
An Art Bubble
All asset classes can't rise together forever. These bubbles too will eventually collapse. Then it's reflation time again.
Ever since markets overran the Fed in the creation of money and credit in the late 1970s, the Fed has overseen a series of bubble booms and bubble busts. Market professionals, especially hedge fund managers, have learned how to position themselves to profit from these boom and bust cycles. Speculators are now well-trained and will be standing by; ready, willing, and able to turn the next post-bust liquidity flow of money their way. To thwart this moral hazard, the Fed has the option of disappointing speculators by failing to supply the guaranteed cash. But with such a high level of corporate and household debt, and capacity globally at historical highs, the Fed runs a very real risk that the real economy will fall into a deflationary depression. This standoff is the great economic and capital markets conundrum of our time, and the steady replacement of the Business Cycle with the Bubble Cycle is the unintended consequence.
The multiple bubbles we are living with now are likely to burst as a result of the Fed current tightening cycle that started in June 2004. If the pattern of the last two tightening periods holds for this cycle, there is reason to expect that at least some of these bubbles will pop sooner rather than later.
How will the capital markets respond to the next post-bubble river of new money? My expectation is that the reflation effort that follows the bursting of the housing, bond, and dollar bubbles that formed during this reflation cycle are more likely to result in a period of high inflation than following previous cycles. The reasons for this are more political than economic. In my next blog, we'll take a stab at predicting how that might unfold.
You may be thinking that this is no way to run a railroad. I leave you with the paragraph that concludes Martin Mayer's book The Fed, which suggests why politicians, who are in a position to address the problem of the bubble cycle before it becomes an even bigger problem, are not motivated to examine the issue carefully today (emphasis added):
"Having won supervisory control over the entire financial services industry, the Fed must bring into the light where the markets can see them continuously the now hidden maneuverings of the private banking empires, the derivatives dealing, the over-leveraging that accompanies over-reliance on diversification and probability. And the Fed has never believed in sunshine as a disinfectant. The tragedy for all of us would be if the Fed's and the Treasury's and the Congress's reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don't know what they're doing."
(This four part series originally published on the AlwaysOn Network will be re-published on iTulip.com in flash-back order, starting with the last in the series and ending with the first, in order to elicit feedback from the iTulip.com community.)
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