Will the Bubble Pop Even if the Fed Never Raises Rates?
There is no ready-made answer in Austrian business cycle theory (ABCT) to the multi-trillion dollar question now looming over the global economy and markets. Is the present virulent asset price inflation disease likely to enter any time soon its final phase of bust and recession? Will this happen even though the Federal Reserve has flip-flopped on even token steps toward policy normalization and leading foreign central banks (i.e., the Bank of Japan, ECB, and Bank of England) to pursue experiments with negative interest rates and novel forms of mega-balance sheet expansion?
Rate Hikes Usually Come Before Crises
In the small sample size of modern business cycles and especially those featuring severe asset price inflation, there is no unambiguous example of transition into the crash and recession phase without a prior significant tightening of monetary conditions. The closest is the 1937 crash and subsequent Roosevelt recession. But the Fed’s attempt to normalize monetary conditions via three hikes in reserve requirements through late 1936 and early 1937 — barely three years on from when the monetary base started to explode under the influence of huge gold inflows from Europe — blurs any lessons which might be drawn.
By contrast, the Fed is now past its sixth anniversary of launching massive monetary base expansion and even wilder monetary experimentation has been occurring abroad. The Yellen Fed has flip-flopped in its program of “rate lift off” on any sign that the S&P 500 might be seriously retreating from present highs. Implicitly, today’s monetary experimenters appear to assume that they can at will exercise a series of “Greenspan (or Yellen) puts” to prevent any serious pull back in market prices until an economic miracle emerges which will justify in fundamental terms presently inflated asset prices.
Many investors around the globe — suffering from interest income famine — are inclined to give the Federal Reserve the benefit of the doubt. Asset price inflation is characterized by the transitory flourishing of speculative stories unchecked by normal rational scepticism which has been numbed by yield desperation. The “success” of The Grand Monetary Experiment has become the biggest speculative story of all.
Strangely, the believers in that story, at least for now, can find superficial solace in early Austrian business cycle theory. This describes how monetary disequilibrium characterized by market interest rates suppressed well below (unknown) natural level generates speculative boom. Eventually a rise of interest rates and tightening credit conditions bring a general bust. So long as interest rates remain around zero speculators might assume they are safe.
According to the early Austrian cycle theorists the rise in rates comes about endogenously as households react to the “forced saving” which they unwittingly undertook during the early boom phase when over-production of capital goods occurs relative to consumer goods. This Austrian narrative explained the great boom in the mid-late 1920s, and the subsequent bust. But it does not apply so well to the present.
Much current “Austrian school” analysis focuses on the irrational behavior in financial markets induced by monetary disequilibrium and the related bouts of mal-investment. In common with the older analysis the role of “over-lending” is a crucial dynamic of the cycle, albeit that irrationality in non-bank credit markets now tops the list of concerns (in contrast to previous emphasis on banks and fractional reserve issues). Possible human behaviors in response to the virulent asset price inflation disease are just too varied for model-based prediction to be successful.
This Time Could Be Different
The sample size of previous asset price inflations is too small to justify forecasts about whether the end phase is likely to be presaged by a tightening of monetary conditions. This time could well be different. A particular attribute of the present asset price inflation disease is the extent to which people are aware of the condition. Many investors looking at the array of high asset prices realize that many of these are far above fundamental value yet desperation for yield defeats cool rationality.
When we normalize US corporate earnings for the effect of “financial arbitrage,” “abnormally cheap interest costs,” and “accounting gymnastics,” we find price earnings ratios today which are not far removed from the stock market peaks of 1929 and 2000. The gap to “fundamental” value is most likely larger than then, given that these peaks occurred in eras of rapid productivity growth and prosperity amidst reasonable expectations that the miracle conditions could continue for at least several years more.
In today’s slow growth economy, business decision makers are understandably cautious. And so ultimately are their shareholders. Long-range projects which potentially pay off in the next recession (which could be very severe due to the extent of prior speculative fever) are widely eschewed, meaning that there is no overall investment boom in the advanced economies despite the cheap cost of capital. Indeed US business investment has been falling now for three quarters.
We're Living Through a Fragile Boom Period
Bouts of highly leveraged speculative economic activity do take place and these can burst without any US-led monetary tightening under the influence of glut and related profits disappointment. The highly leveraged investor in shale oil or in emerging market industries hoped to earn mega riches thanks in large part to the fantastically low cost of debt within a few years even if understandably dubious about the possibility of selling out his equity position before the downturn. Leverage brings forward the potential realization of speculative profit.
Equity investors in general realize that there are these big areas of highly leveraged overinvestment and mal-investment and that the next recession may well originate from there. Now, many question the sustainability of commercial real estate booms whether in the US or in the emerging market world — alongside several residential hotspots. Overbuilding, rental declines, and vacancies are the catalysts to bust without any rise in rates.
And yes, the possibility of speculative boom and bust exists in some areas of economic activity where high leverage is absent. That occurs where there has been the hyped up speculative narrative alongside booming carry trade activity — in this case from lower yielding liquid assets into higher yielding illiquid assets — with the income famine-crazed participants underestimating the risks. Unicorns in Silicon Valley, and more generally venture capital funds, may fit this description. These often have highly leveraged twins in private equity.
Historically, monetary tightening has been a fatal blow to these carry trade booms which thrive in early and mid-phases of asset price inflation. There can be a long lag between the blow and the bust which might occur well beyond the tightening having given way to super-ease. It is possible that today’s carry trade booms — whether in credit, illiquidity, or ultimately equity and real estate — will burst without any further tightening episode beyond those very slight Federal Reserve maneuvers of 2013–15. Future historians might blame the bust on those maneuvers. At least we present-day commentators who might disagree can write, like Josephus, that we saw these events with our own eyes.