Balloon recovery – part 1

Five years after the start of the Great Recession, we can take stock that the much-dreamed-of economic recovery of the global economy is missing.

As can be seen in Chart 1, the real GDP (abstracting from the shortcomings of this indicator, which I have already commented on ) of only two of the countries presented in the chart has returned to its 2008 levels. Moreover, the entire period after the outbreak of the crisis was accompanied by a very loose monetary policy by the major central banks, which led to the inflation of their balance sheets (see Chart 2), artificially low interest rates, an increase in the amount of global debt and the subsequent inflation of a number of bubbles in various asset classes and sectors of the economy.

Graphics 1

Graphics 2

Where did the central bankers go wrong?

In response to the Lehman Brothers bankruptcy in September 2008, central banks around the world started printing presses and began to pour liquidity into the financial system, under the pretext that this would save many banks and large companies from bankruptcy, preserving jobs and protecting the confidence of consumers, investors and savers from collapse. The actions of central bankers were also dictated by concerns about deflation, which they greatly abhor, especially in financial assets. However, the latter have clearly not learned their lessons in economics well, because they forget that deflation is the necessary remedy for an artificially inflated and debt-laden economic growth, such as we witnessed in the years before Lehman's bankruptcy.

Ever since the bursting of the dot-com bubble at the beginning of the new millennium, central banks around the world have been implementing loose monetary policies in order to stimulate lending and hence investment and consumption. At the same time, however, whether intentionally or not, little attention was paid to the fact that such a monetary policy discourages saving, and artificially low interest rates give the wrong price signal to economic agents that there is a sufficiently large amount of saved resources available for investment and consumption. The policy of “easy money” leads to unwise investments (malinvestments), excessive consumption of otherwise unnecessary goods and services, and the accumulation of debt.

There is only one way out of this process – bankruptcy on the accumulated debts, bursting of the inflated bubbles (deflation) and restructuring of the economy. The consequences of this are severe and the negatives are felt in the short term, giving the economy the opportunity to start growing sustainably in the long term. This does not please politicians, whose decision-making horizon coincides with their short mandate, and therefore we have witnessed unprecedented measures by central bankers, aimed at preserving the status quo and postponing the problems to the future, when most likely some other politician (preferably from the opposition party) will have to bear the burden.

Where did we get it?

As mentioned at the beginning of the article, the economic “recovery” is currently accompanied by the inflation of numerous bubbles and the accumulation of more debt at the state and private levels. Central bankers are using the same tools (loose monetary policy) that brought us to this situation as a means of solving the problems. We are witnessing the inflation of a second real estate bubble in the US, bubbles in the global financial stock, commodity and debt markets and of course, let’s not forget perhaps the biggest bubble at the moment – China – and all this thanks to central bankers, who through their verbal and factual intervention take care of the “good” of the people.

Balloons in the USA

The US economy is a good example, precisely because the bursting of the real estate bubble there a few years ago had a strong impact on the global economy. Apparently, politicians and central bankers have a rather short memory after trying to repeat their mistake from a decade ago. In April, US housing prices (measured by the CoreLogic Pending House Price Index) rose for the 14th consecutive month by 12.1% on an annual basis, the strongest increase since February 2006. This is happening in the context of weak economic growth (1.8% on an annual basis in the first quarter of 2013), a falling employment rate (ranging between 58-59%, compared to levels of over 63% in 2007), and falling wages in real terms (a decline of 0.2% in 2012). This does not prevent Federal Reserve Chairman Ben Bernanke from repeatedly repeating that the US housing market is recovering because prices are rising. We are witnessing a deficit of conventional logic and the pursuit of the mantra that when financial asset prices rise, the economy is recovering. In other words, when an asset is twice as expensive tomorrow for an ordinary person, his well-being has increased.

The reason for the aforementioned dynamics in US house prices is our well-known monetary policy. Through its commitment to maintain the interbank interest rate at levels of 0-0.25% by purchasing government debt and mortgage bonds for $85 billion each month, the Fed managed to reduce the interest rate on 30-year mortgage loans to record lows (see Chart 3). The artificial reduction in the price of mortgage loans below the market led to an increase in demand for these products, which in turn gave a new impetus to property prices in the largest economy in the world.

Graphics 3

Another bubble in the US that has become more apparent in the last few months is that of the financial markets, and more specifically in the prices of stocks and bonds. While the bubble in the US sovereign debt was inflated for 5 years, the one in the stock market gained strength relatively recently. The reason I call these markets bubbled is very simple - we have a complete mismatch between prices and fundamentals in the conditions of "easy money". In the bond market for government debt, interest rates have reached record low levels in the conditions of a slowly decreasing budget deficit, a huge amount of government debt and promises of social payments (unfunded liabilities) by the US government amounting to several times GDP. On the other hand, the intervention of the Fed in this particular market itself speaks of the reluctance of other players to buy these assets, and this artificially increases their price. The picture is similar on the stock market - the major indices are growing and reaching historic highs amid weak economic growth in the US and slowing growth in emerging markets.

Many analysts denied and continue to deny that the policy of “easy money” will lead to inflation. In these forecasts, however, they speak of price inflation, i.e. inflation measured by the consumer basket of the Consumer Price Index ( CPI ). As has been mentioned more than once, inflation is actually an increase in money supply beyond money demand, which in turn leads to an increase in the prices of those goods, services and assets to which the newly created money is directed. By this definition, in recent years we have witnessed strong inflation, especially in developed countries, which in turn led to an increase in the prices of a number of assets – housing, stocks, bonds, raw materials, etc.

In other words, the newly created money by central banks was directed towards certain asset classes and even entire economies (hot money directed towards developing countries in search of higher returns) rather than being used to lend to businesses and households, which led to a bunch of bubbles inflating and low price inflation (measured by the CPI). The bursting of these bubbles will sooner or later lead to another crash in the financial markets, and this time the central banks will have their hands tied, as their interventionist tools will no longer work.

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