Munchau: Next Crisis Coming Sooner Than You Think

Wolfgang Munchau has a solid, thoughtful piece at the Financial Times which argues that the widely applauded rallies in stock and commodity markets are already looking very much like bubbles, and the efforts to contend with them (either directly, or as a result of the need to start reining in liquidity) is likely to kick off another crisis.

That much had been said in various ways in other venues, although Munchau does offer valuation data to back up his views. The more novel part of his argument is that instability is the inevitable result of an overly-large financial sector, and the result is bigger and bigger swings in output (meaning GDP growth) and prices.

Ouch. And the two scenarios he sets forth are not pretty either.

From the Financial Times:

On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner.

So how do we know this is a bubble? My two favourite metrics of stock market valuation are Cape, which stands for the cyclically adjusted price/earnings ratio, and Q. Cape was invented by Robert Shiller, professor of economics and finance at Yale University. It measures the 10-year moving average of the inflation-adjusted p/e ratio. Q is a metric of market capitalisation divided by net worth…

…they both tend to agree on relative market mispricing most of the time. In mid-September both measures concluded that the US stock market was overvalued by some 35 to 40 per cent. The markets have since gone up a lot more than the moving average of earnings….

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets…

But unlike five years ago, central banks now have the dual role of targeting monetary and financial stability. As has been pointed out time and again, those two objectives can easily come into conflict. In Europe, for example, the European Central Bank would under normal circumstances already have started to raise interest rates. The reason it sits tight is to prevent damage to Europe’s chronically under-capitalised banking system, which still depends on the ECB for life support. The same is true, more or less, elsewhere.

Now, I agree there is no prospect of a significant rise in inflation over the next 12 months, but the chances rise significantly after 2010.

Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control.

This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.

While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instabiliy….The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.

His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.

Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages.

Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.

In other words, there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

For all we know, there may not be a safe way down.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

One Response to "Munchau: Next Crisis Coming Sooner Than You Think"

  1. jrt   October 23, 2009 at 5:19 pm

    We’ll have both inflation and deflation happening simultaneously in different parts of the real and financial economies.As the real and financial economies decouple, capital allocations are becoming incredibly distorted. This always happens but the magnitude is staggering now. I’m in my 50’s but even the 70 and 80 year olds haven’t seen anything like this!In general the real economy is deflating (tied to people’s finite time and physical assets) while the financial economy (tied to pure information and theories via computer models) is moving in strange ways.James Grant changed his view of inflation from “too much money chasing too few goods” to “too much money”. (The money keeps changing what it chases).Central banks are attempting to counteract the contraction in debt (deflation). If we have exceeded the ability to repay debt (see Minsky and Irving Fisher) then their behavior will inequitably reallocate capital.Here are some common sense examples:1)I see junior brokers receiving multi-million$ bonuses, believing it is not much money, and I am on the board of a company solving energy crisis problems for Fortune top 10 unable to raise capital as Venture and other sources contract.2) My 14yo son earns .5% on his savings account and I pay 14% on credit cards. (He can’t lever-up and play the spread even if he knows how)Now I may not be a genius, but we are collectively flunking an IQ test.Taleb made it clear in the Black Swan that nature doesn’t create these distortions/distributions, only man-made things (like information/money).RISKY DECISIONS IN BANKING HAVE BECOME FRICTIONLESS AS GLOBAL FIAT CURRENCY BASED ECONOMIES APPROACH SATURATED DEBT LEVELS.What is a sustainable debt level? Private, corporate and public?Whether it is extinguished with monetary/fiscal default, slow payback or inflation, I believe the unintended consequences of distorted capital allocations will be more damaging than any fear the FOMC or congress worries about.