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Market bubble being reinflated?
By MATHEW INGRAM, Globe & Mail
Many economists believe the U.S. economy is on its way back to health. The unemployment picture is improving; the manufacturing sector seems to be growing slightly -- after two years of stagnation -- and consumer confidence is fairly high. Housing, auto and retail sales continue to be strong, and the stock markets have roared higher over the past few months based on the hoped-for recovery. So what is the U.S. Federal Reserve Board doing? Pumping liquidity into the economy as fast as it can, with yet another interest rate cut expected soon.
In fact, much of the activity that the U.S. economy and the stock markets have seen over the past year has been a result of having Fed chairman Alan Greenspan's foot on the central bank gas pedal, as well as the effects of a massive tax cut program from the Bush government and the stimulus of a falling U.S. dollar. A bank rate lower than it has been since 1961 has encouraged both businesses and individuals -- and particularly homeowners -- to borrow money at extremely low rates, just as the car companies have spurred sales with zero-interest financing.
The Fed has even raised the idea of taking more aggressive steps to boost liquidity, such as buying long-term government bonds to drive the yields on those bonds down, which in turn would lower long-term rates. Newly appointed Federal Reserve governor Ben Bernanke mused in a speech last fall that the U.S. government has unlimited room to stimulate the economy -- because it "has a technology called a printing press . . . that allows it to produce as many U.S. dollars as it wishes at essentially no cost." In other words, the Fed has unlimited ammunition.
This kind of talk has helped to support the rise in the stock markets, a rise that has seen the major market indexes climb by more than 25 per cent in the past three months, and more than 30 per cent since October (the Nasdaq is up almost 50 per cent). It seems obvious that Mr. Greenspan and the Bush administration intend to do everything in their power to jump-start the economy. But what if they are too successful and just wind up reinflating the bubble?
According to some estimates, M1 -- a measure of money supply -- has been growing at an annual rate of close to 30 per cent over the past few months. "What Japan has shown us is that the way to fight deflation is to get rid of overcapacity as fast as you can," Merrill Lynch market strategist Richard Bernstein said recently. "The Fed is doing the exact opposite now. What the Fed is doing is keeping the oversupply situation intact by lowering the cost of capital."
The central bank has been redoubling its efforts to reboot the economy because it is deathly afraid of the United States turning into Japan. Mr. Greenspan and others are worried that if the U.S. economy stagnates for too long, it will become trapped in a quagmire of virtually zero growth from which it will be very difficult to escape, as Japan has been for the past decade or so. The prospect of systemic deflation is so dire that the Fed chairman has said he is willing to do whatever it takes to avoid it, even if it means using tools the Fed hasn't used in 50 years.
The last time the U.S. central bank got this worked up about something was the late 1990s, when Mr. Greenspan and his team stepped in to avert the potential financial disaster they saw coming as a result of the currency crisis in Russia and the "Asian contagion." The Fed also orchestrated a bailout of the ironically named hedge fund Long-Term Capital Management, and then began injecting liquidity into the market because of fears that the Y2K bug might cause a financial panic of some kind. That was three pumps of the gas pedal.
Some central bank critics argue that all of this liquidity helped to fuel the stock market bubble that began inflating in the late 1990s and finally burst in 2001 -- because it not only provided lots of easy money but encouraged investors to believe that Mr. Greenspan was on their side. It's possible that the same kind of situation could be created now, because both the stock market and the housing market are at levels that have some analysts using the "B" word.
According to Merrill Lynch economist David Rosenberg, U.S. mortgages have grown 13 per cent in the past year, and now make up a record 30 per cent of non-financial debt.
Household debt levels rose faster in the past six months than at any time since 1986, and household debt relative to income hit a new high: 111 per cent. "This is what Fed policy is accomplishing -- akin to giving another drink to the inebriated sailor," Mr. Rosenberg said. "One characteristic of a 'bubble' is excessive leverage. That definition seems applicable in this case."
Will all the Fed's stimulus spark real growth, or another series of bubbles that will blow up in the market's face? Mr. Greenspan doesn't seem concerned -- but then, he rarely does.
Mathew Ingram writes analysis and commentary for globeandmail.com.
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