How to Spot A Bubble....

It seem obvious to just about everyone that we are in the middle of another asset bubble. I've been exploring that in my Money Week column this week. Here's a taster.

A year into the greatest downturn since the great depression of the 1930s, there is still no real consensus on what caused the sudden collapse in the financial system. Greedy bankers? Lax regulations? Global imbalances? You can take your pick from an intellectual buffet table laden down with different theories.
But one thing seems to unite just about every shade of opinion.
In the years running up to the credit crunch, the US Federal Reserve, along with other central banks, ran far too loose a monetary policy. They kept interest rates too low for too long, inflating asset bubbles in everything from houses, to credit derivatives, to fine art.
Everyone, that is, except probably the most important figure in the global financial system, the Fed chairman Ben Bernanke.
In a speech earlier this month, Bernanke re-trod the same intellectual ground as his predecessor, Alan Greenspan. You can’t spot bubbles, and even if you could, you can’t do very much about them.
The trouble is, if we can’t learn from the mistakes of the past, then we will just keep repeating then. The reality is, you can spot a bubble, and you can do something about. And only by doing so can you start to put the global financial system in better shape.
Reading Bernanke’s remarks to an audience in New York earlier this month, it was impossible not to be transported straight back to the Greenspan era. “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value,” he said. “It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.” The best approach he argued was to regulate the financial players in the markets properly “and to make sure the system is resilient in case an asset-price bubble bursts in the future.”
It was very reminiscent of the argument of his predecessor, all through the dot com era, and the property and credit bubble that followed it, that it was not the job of central bankers to go around spotting bubbles. Nor was it their job to prick them. All they should try and do was clear up the mess afterwards. With varying shades of enthusiasm, that argument was followed by central bankers the world over. Our own Mervyn King, the Governor of the Bank of England, fretted publicly about the level of house prices in the run up to the crash. But he never actually raised interest rates to stop prices rising further. Was property a bubble or not? Too hard to tell, decided the Governor.
In fairness, there is an intellectual case to be made for that argument. In a free market, it’s hard to tell the difference between a bubble, and a shift in prices.
So, for example, if the price of oil doubles, that might be a bubble. Then again, it might be a rational response to a shift in supply and demand. If the world really is running out of oil, it makes sense for the price to soar: in response, we’ll find ways of using less of the stuff, and the exploration companies will invest more money finding new sources of supply.
It is not a bubble – it’s just prices changing. In a free market, that happens all the time. Try and stop it, and the market won’t work anymore.
On top, of that, it isn’t obvious that we’re in a bubble right now. Bernanke referred to the 63% rise in US stocks since the depths of the crisis last March. That was just getting back to normal prices, he argued. And he has a point. At a cyclically adjusted PE ratio of 20, US stocks aren’t cheap – but they are well below the PE ratio of 44 they hit at the peak of the dot com boom.
That said, there are clear signals that what the financial markets are experiencing right now is indeed a bubble -- and one caused by record low interest rates, and central banks printing money like crazy.
It might not be evident in stock prices – yet. But there are plenty of signs elsewhere.
Commodity prices are soaring, even as industrial production remains subdued. Take aluminium, for example. Its price is up by 33% so far this year, even though there is enough of the stuff sitting in warehouses to build 69,000 Boeing jumbo jets. How can you explain that, except that there is too much speculative money flowing into the system?
Bankers are paying themselves huge bonuses. There isn’t much sign of a pick-up in basic lending, or the profitability of past loans, but they are minting a fortune from their trading operations. Even hedge fund launches are picking up once more. Again, sure signs of a frothy financial system.
The carry trade – borrowing in a cheap currency and investing in an expensive one – is booming just as it did for much of the noughties. Last time around, firms borrowed in yen, and invested in the US or UK. Now they borrow in pounds or dollars, and investing in emerging markets. The result is the same – asset prices soaring on the back of borrowed money.
Even luxury, trophy assets are fetching record prices – another certain sign there is a lot of hot cash swilling around the system.
The real issue is not whether we are in a bubble right now. There are arguments on either side of that question. The point is whether central bankers – in both the US and Europe -- are prepared to look for bubbles and try and stop them. It isn’t enough to argue that central banks should just wait until a bubble has burst before they deal with it. They tried that last time around – and the results were hardly encouraging. The bubble had grown so enormous that it could not be unwound easily. As it burst it plunged the world into a recession that may take a generation or more to recover from.
True, spotting bubbles is difficult. Deflating them is hard work. But that is no excuse for not trying. And if the world’s central bankers haven’t grasped that yet there isn’t much hope of avoiding another crisis a few years down the line.