Financial Bubbles: The Next Headwind in Global Economic Recovery

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World Focus
 
--By Sanjeev Sharma
 
The global economic recovery is apparently picking up momentum as bleak prospects outlining the world’s economy seem to have slowly faded away. International Monetary Fund (IMF), in its latest World Economic Outlook, projects a global growth of 3.6 per cent for 2014, up from the 2.9 per cent forecast for 2013. Led by the impressive economic performance of United States, global economy is recovering from its deep wounds inflicted by the financial crisis of 2008/09. Pausing of Eurozone’s long-standing sovereign debt crisis and economic slowdown in emerging economies are also signs that dark cloud over the global economy is gradually disappearing. 
 
However, this exhilaration over global recover may not last long as some serious economic headwinds are appearing in the horizon. Reemergence of financial bubble, as seen by many prominent economists, is one of the threatening and dampening prospect to the world’s still fragile economy. Economists are clearly indicating of the bubbles that are brewing up in major financial centers across the world. The bubbles, according to them are forming in stocks, bond, currency, real estate along with other high-value assets. Various theories define bubble as an economic phenomenon that occurs when asset prices soar far above their actual value. The high prices then turn untenable and they fall dramatically until the overvalued assets are valued at or even crash below their actual worth (bubble burst). Speculative pricing of assets is often blamed as the major contributing factor for this. According to well known Forbes columnist, Jesse Colombo, “A bubble trajectory is one in which economic growth is driven by rapid credit growth, soaring asset prices, speculation, a debt-fueled consumption boom, a low savings rate, lofty financial sector profits, and nonsensical business booms.”
 
So, what is the reason behind the formation of bubbles? The answer lies inmassive supply of cheap money by the major central banks. Immediately after the financial crisis in 2008, central banks of US, Europe and Japan accompanied by their counterparts in the emerging economies of Asia, Latin America and elsewhere started to flow money into the financial markets on an unprecedented scale. By slashing interest rates to historic lows, they eased monetary policies to stimulate economies of their respective countries. Monetary easing, namely Quantitative Easing (QE),meanwhile, became an effective weapon to combat financial crisis and recession. Easy access to cheap money stopped drying of credit markets resulting inthe rise of confidence among consumers, investors and businesses. But, stimulating economy through monetary easing is also likely to carry risks such as inflation and financial bubbles. Inflation, as feared many did not rise even after the epic scale pumping of liquidity into the markets. Huge gaps in economic outputs of developed economic helped check the inflation. On the contrary, the stimulus programmes seem to be encouraging bubbles in financial markets. In response to the financial crisis, the world’s major central banks pumped more than USD 20 trillion into the global economy over the past 5 years. Despite the US Federal Reserve’s recent tapering of QE by USD 10 billion per month, central banks are seen sticking to their stimulative monetary policies. 
 
The global economy is no stranger to bubble bursts. The timeline of economic turbulence across the globe gives a clear insight of such phenomenon. During the 1920s, the US saw a large stock market boom, particularly from 1927to 1929. That was followed by the stock market crash of 1929 and the Great Depression. Similarly, Kuwait’s Souk Al-Manakh stock bubble in the early 1980s shows problems in financial market from different spectrum. Bubble began to form in the oil rich nation’s equity market when sometraders speculated in stock prices of local companies. Investors were permitted to make payments for stocks using unsecured post-dated cheques. The stock market authorities made faulty assumption that defaultwould be unimaginable for Islamic cultural reasons. However, as the speculations grew over the stock prices, the inflated bullish market finally burstlike a balloon. 
 
Black Monday or the stock market crash of 1987 is another notable example when the DOW Jones index made its biggest one-day loss in the history. The exuberant stock market fueled by merger and acquisition mania and hostile takeovers of the 1980s fell on its knees on Monday, 19th October, 1987. This was caused by the use of a new tool called ‘Portfolio Insurance’. As the market began to drop from its multi-year highs, the tool which was designed to save investors from further loss instead prompted massive sell-orders leaving the DOW index to plunge by a whopping 22.6 per cent by the end of the day. 
 
In Japan, similar phenomenon was seen in the late 1980s. During the mid 80s, electronics and automobiles manufacturing along with aggressive financial sector and infrastructure boom soared real estate and stock prices which eventually formed ‘bubble economy.’ The bubble peaked in late 1989 and Japan’s highly-inflated stock and property markets began to crash. By 1992, the Nikkei stock index nose-dived to 15,000 points from its peak of nearly 40,000 points.For about two decades (1991 to 2010), Japan recorded a near zero economic growth and fast rising deflation, this era being called the ‘lost decades.’
 
The DotCom bubble burst of late 1990s is another example of financial disaster instigated by speculative stock pricing. Rapid expansion of computer and internet market in late1990s led to the sky rocketing of stock prices of tech companies in New York’s Nasdaq exchange. As more and more investors flocked to the tech stocks without even knowing the financial position of newly formed IT companies, bubble was created in the market. In mid-March 2000, after many of those companies posted negative revenues, Nasdaq Composite index began its freefall pushing the US economy into recession. 
 
In response to the DotCom bubble burst and terrorist attacks of 9/11, US Federal Reserve cuts interest rates to boost the liquidity into the market. This gradually led to the rise of real estate and stock prices. Also the relaxing of requirements for subprime mortgage loans in mid-1990s encouraged individual home buyers and institutional investors to purchase more of these unsecured debts. As the riskier debts were distributed in the form of mortgage-backed securities, bubbles popped out in the financial markets of western nations. In 2006, when interest rates rose and mortgage loan terms changed, home prices began a rapid decline which eventually led to the housing bubble burst and financial crisis. Eurozone, meanwhile, experienced sovereign debt crisis which is seen as a explosion of accumulated public debt as spending of the governments climbed up to unmanageable levels. 
 
World Focus
 
In 2013, gold market also suffered a bubble burst. After twelve years of straight gains, gold prices slumped sharply in mid-April following the news of debt-stricken Cyprus selling some of its reserve. In fact, price of the yellow metal was about to explode due to the low inflation rate in advanced nations and rallying stock markets. The bullion, which peaked to its all time high in September 2011 (USD 1920 per oz), declined to USD 1,180 per oz in late June in the wake of QE tapering signals from the Federal Reserve. For 12 years, gold benefitted from lower interest rates and sentiment of investors who feared hyperinflation. 
 
As the central banks of major economies are busy in money printing activities, historic surge in stock markets are giving off resounding alarms. Similarly, rising houses prices in developed and developing countries is another concern among analysts. “I am not yet sounding the alarm. But in many countries stock exchanges are at a high level and prices have risen sharply in some property markets,” Robert J. Shiller, winner of this year’s Noble Prize in economics for research in market prices and asset bubbles told the German weekly magazine Der Spiegel recently, indicating to the US stock market rally and overheated Brazilian property market. “That could end badly,” said the Yale professor who won the prestigious award with two other fellow Americans. 
 
Similarly, Prof Nouriel Roubini in his recent article entitled ‘Back To Housing Bubble’ writes, “Signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK. In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.” The forecaster of financial crisis indicated to the fast-rising home prices, high and rising price-to-income ratios, and high levels of mortgage debt as a share of household debt as the signs of home prices entering bubble territory in these economies. “What we are witnessing in many countries looks like a slow-motion replay of the last housing-market train wreck. And, like last time, the bigger the bubbles become, the nastier the collision with reality will be,” Roubini warns.  

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