Tuesday, January 13, 2009

Bubblegum Economics

If it's big and pink and wobbly, it's probably a bubble

If you haven't yet watched Jeff Randall's excellent interview with Chancellor Darling, you really should (here). The great thing about Randall is that he understands how economics and finance works, and has the facts at his fingertips - which is a lot more than our usual TV interviewers. As a result he was able to give us a proper discussion about the underlying issues, rather than the usual look-at-me stuff.

As has been widely reported, Randall put it to Darling that the government owes us all an apology for getting us into this mess in the first place. Needless to say, Darling declined the opportunity and trotted out the old line about how it's a global problem, and with the benefit of hindsight everyone would have acted differently. How were they to know?

But of course, as Randall suggested, that really won't do. The current crisis is the result of a huge credit bubble bursting, and our government was centrally involved in inflating it in the first place. Let's recap:

  • They maxxed out the public sector's own credit cards, leaving nothing for that rainy day
  • Their tax changes encouraged companies to gear up with much more borrowing (eg see this blog)

  • They ignored the huge growth of personal debt, much of it "secured" against a ludicrously overpriced property market, which had itself been driven up by the credit bubble; household savings collapsed (eg see this blog)

  • They ignored the huge growth in our overseas debt (not just the borrowing to fund our ballooning current account deficit, but also massive borrowing to fund our banks/hedge funds)

So why did they let it happen?

The excuse that nobody knew it was a bubble at the time is pretty thin. On virtually all measures, credit was exploding and property prices were unsustainable. The bubble featured regularly in every newspaper from the Gruaniad to the Mail.

A more credible version of why we had official inaction is that, while plenty of people said it was a bubble at the time, there was no way of proving it. And governments and central banks had come to be very circumspect about second-guessing markets. As Fed Chairman Alan Greenspan famously put it in 1998:

"There is a fundamental problem with market intervention to prick a bubble. It presumes that you know more than the market.”

Now Tyler has a lot of sympathy with that point. Governments and their agencies - including central banks - have a long and expensive history of unsuccessful attempts to buck markets, and the Big Picture conclusion is that it's almost always best to leave things to the market itself.

But in this case of course, the market seems to have failed. Or to put it more precisely, it seem to have blown us all to buggery.

Greenspan has at least had the backbone to admit he got it wrong. Back in October he said:

"I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. And it's been my experience... that the loan officers of those institutions knew far more about the risks involved in the people to whom they lent money than I saw even our best regulators at the Fed capable of doing.

So the problem here is, something which looked to be a very solid edifice, and indeed a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me.

I still do not fully understand why it happened. And obviously, to the extent that I figure out where it happened and why, I will change my views. And if the facts change, I will change."

No such admission from Darling last night, although you can be sure he's happy to go along with the bit that blames the bankers for not "protecting their own shareholders and their equity in the firms" (aka evil bankers robbed everyone, including their own shareholding grannies).

But is Greenspan's confession the real reason that governments and their central banks were so hands off with the giant bubble? Was it really because all agreed that markets always know best?

Or was it perhaps that the growth, employment, and votes generated by a runaway credit boom were simply too good to pass up?


With the benefit of hindsight, it is clear that central banks should have been far more willing to prick bubbles over the last two decades.

And perhaps even more important, they should have been far less willing to reinflate them once they'd burst. The notorious Greenspan put (see this blog) kept the US equity market motoring right up to the dot.com collapse, and then he compounded the problem by slashing interest rates just in time to fuel the mad, and nearly terminal, sub-prime mortgage bubble.

Just as Keynesian fine-tuners once thought that if they managed aggregate demand, everything would be fine, so today's central bankers had come to believe thay if they just managed the official inflation rate, everything else would somehow take care of itself. Both turned out to be wrong.

From the South Sea Bubble to the 2004-2007 housing market, we've always had asset bubbles. And we probably always will. But we shouldn't have to accept governments and their agents ignoring/conniving in them. At 40% of the economy, we should expect them to be a stabilising influence.

And that doesn't just mean slashing interest rates and pumping in billions of taxpayers' money when bubbles collapse. It also means spotting possible bubbles well before they get to bursting point, and taking action then.

Yes, we can all see bubble spotting is not an exact science. But you know what - if it's big and pink and wobbly with flecks of spital on it, it's probably a bubble. Just like the one we currently have in the government bond markets.

The fundamental problem is the other one - calling time on a party is never ever going to be popular. But as this lot will discover next April, neither is getting everyone covered in masticated bubblegum.

PS Tyler used to be a master in the great art of bubble-blowing. But being of limited means, he couldn't run to more than one piece of bubblegum a day. Which meant traditional mealtime storage behind the ear. Unfortunately, while taking tea one day with a rather intimidating great aunt, he inadvertantly gummed his head to her high-backed antique chair. She was somewhat less than amused. In fact she dragged him into what she called her scullery (do they still exist?) and proceeded to scrub behind his ear with said scullery brush. These days, she'd have been put inside... except of course, we have no prison places, and are unlikely to afford any ever again.

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