Based on both recent history and mainstream economic theory the past few years
should not have been possible. When you cut interest rates to near-zero, run
deficits of 10% of GDP and buy up every government bond in sight with newly
created currency, you get a boom, end of story. That's just the way capitalism
works.
But this time was different. After four years of QE and ZIRP and all the other
easy-money acronyms, we entered the month of May with Europe in a deepening
recession and the US
recovery petering out.
The culprit? The one piece of the puzzle that governments can't control: the
velocity of money. This is simply a measure of how quickly holders of currency,
i.e., banks, consumers, businesses, hand their currency off to someone else.
The faster and more frequent the hand-offs, the more stuff gets bought and
the more robustly an economy grows. But after their 2009 near-death experience,
the world's banks have been in no mood to lend. Instead, they've been sticking
all the new currency their governments have been giving them under the proverbial
mattress. This reluctance to lend means record low money velocity and little
or no economic growth.
But in just the past month something fundamental has changed. US home sales
and prices have accelerated, with prices returning to 2006 levels in some
markets and bidding wars, flippers and interest-only mortgages once again
becoming common. Stock prices pierced old records and then spiked rather than
corrected. Suddenly we're back in an asset-driven boom.
But it's a boom with a twist because it coincides with unprecedented amounts
of "excess reserves" in the banking system. This is the raw material for new
loans, and banks across the country are worrying that they're missing the
boat by remaining in cash. Marginal mortgage applicants now look a lot more
attractive because their collateral is appreciating. Private businesses, judged
by the share prices of their publicly-traded peers, are becoming more valuable
and hence more creditworthy. Families with rising stock portfolios and appreciating
houses suddenly look like better bets for car loans.
So what happens if a tidal wave of bank reserves are suddenly converted to
business and consumer loans at a time when asset markets are already overheated?
Maybe the fabled crack-up boom of Austrian economics. A couple of weeks ago Daily
Reckoning addressed this issue in an article that quoted Ludwig von Mises'
famous definition of a crack-up boom:
This first stage of the inflationary process may last for many years. While
it lasts, the prices of many goods and services are not yet adjusted to
the altered money relation. There are still people in the country who have
not yet become aware of the fact that they are confronted with a price
revolution which will finally result in a considerable rise of all prices,
although the extent of this rise will not be the same in the various commodities
and services. These people still believe that prices one day will drop.
Waiting for this day, they restrict their purchases and concomitantly increase
their cash holdings. As long as such ideas are still held by public opinion,
it is not yet too late for the government to abandon its inflationary policy.
But then, finally, the masses wake up. They become suddenly aware of the
fact that inflation is a deliberate policy and will go on endlessly. A
breakdown occurs. The crack-up boom appears. Everybody is anxious to swap
his money against 'real' goods, no matter whether he needs them or not,
no matter how much money he has to pay for them. Within a very short time,
within a few weeks or even days, the things which were used as money are
no longer used as media of exchange. They become scrap paper. Nobody wants
to give away anything against them.
It was this that happened with the Continental currency in America in 1781,
with the French mandats territoriaux in 1796, and with the German mark
in 1923. It will happen again whenever the same conditions appear. If a
thing has to be used as a medium of exchange, public opinion must not believe
that the quantity of this thing will increase beyond all bounds. Inflation
is a policy that cannot last.
So how close are we to the point where "finally, the masses wake up?" Hard
to say. Stocks and houses are back at previous-bubble levels and there's even
talk of a shortage of government bonds. And based on the excited emails pouring
in from people who, after a decade of bad returns have seen their aggressive
growth funds rise by 25% in a quarter and are feeling like geniuses, animal
spirits are back and happy. All while bank lending has barely started to ramp
up. It's safe to assume that banks getting into the game would heat the markets
up even more.
How would today's financial system handle the resulting volatility? Prudent
Bear's Doug Noland addresses this in his most recent Credit Bubble Bulletin:
I don't mean to imply that today's environment is comparable to 1999. The
U.S. economy was sounder in 1999 - and the global economy was a whole lot
more stable. Global imbalances in 1999 were insignificant compared to the
present. The U.S. economic and Credit systems had yet to be degraded by
a doubling of mortgage debt and a massive misallocation of resources. The
federal government hadn't doubled its debt load in four years. Europe had
not yet terribly impaired itself with a decade of runaway non-productive
debt growth. China and the "developing" economies had not yet succumbed
to historic Credit booms, overinvestment and economic maladjustment. Central
banks hadn't yet resorted to really dangerous measures.
The implication: This world, levered to the hilt in response to the policy
mistakes and financial crises of the past few decades, is more complex and
fragile than the systems that (barely) survived the bursting of the tech stock
and housing bubbles. So this bubble and its aftermath might be a whole different
animal.
