Of Asset Bubbles and Bursts

by Jérémie Cohen-Setton on 15th November 2009

What’s at stake: Concerns are mounting that efforts by governments and central banks to stoke a recovery will create a nasty side effect: asset bubbles in real-estate, stock and currency markets, especially in emerging countries. Prices are surging across a host of markets. Gold is up about 44% this year. In the U.S., risky assets are rising rapidly in price: The risk spreads, or interest-rate premiums, on low-rated junk bonds have narrowed to about where they were in February 2008, before Bear Stearns and Lehman Brothers fell.

Nouriel Roubini says that the mother of all carry trades is behind the massive rally in risky asset prices, setting up the biggest co-ordinated asset bust ever. A more important factor than the wave of liquidity from near-zero interest rates and quantitative easing fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. As Felix Salmon puts it, investors are making money on three different legs at once: they not only pocket the interest differential between the funding currency and the higher-yielding target currency and capital gains from the appreciation of the target currencies as these trades start becoming crowded, but also make money from the depreciation of the funding currency. The unravelling of this carry trade may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash.

Models and Agents is amazed with the number of academics, journalists and pundits who keep on talking about “the carry trade” as if it is some sort of cult. Since last week, the carry trade has even found a mother, a father and some heavyweight patrons who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions. Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009. Low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. Given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

Frederick Mishkin says that not all bubbles present a risk to the economy. Credit bubbles are dangerous, others aren’t. Pure irrational exuberance bubbles are far less dangerous because they do not involve a cycle of leveraging against higher asset values. Without a credit boom, the bursting of a bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons why the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

The Economist’s Free Exchange blog says that sure, bubbles are one threat among many, but that doesn't mean they're anything like the most dangerous one. Even if Roubini's explanation were the one that best fits what's happening, they do not worry too much that this might go on for a while, building into a new and terrible bubble. For the moment at least, markets are looking for dollar stability, and perhaps a slight rebound through 2012, as the Federal Reserve unwinds its market interventions and raises rates. Furthermore, pulling back on monetary policy too soon amid recovery from one of the century's worst recessions would be much more painful than another tech stock boom and bust.

Willem Buiter says that the credit and asset market boom, bubble and bust he foresees for the rapidly growing emerging markets is not inevitable.  It is a policy choice.  If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

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