Hot on the heels of a recent post where John takes on 19 economists in the FT here's some thoughts from him on the big question of bursting bubbles
We thoroughly encourage your comments here. Agree ? Disagree? Why?
The debating floor is yours, but first let's here from John
The bubble will burst (just don`t ask me when)
Have you ever known a bubble not burst? Here we are talking
about the financial bubble in asset prices that has been created by damagingly
low interest rates on official borrowings and, which in
turn has pulled down all other savings rates.
Six years of low, and more recently negative rates of
interest, around the world have inflated asset values particularly in the
ownership of shares, houses and other forms of property that have a speculative
value. For the sake of brevity we will refer to all of these as assets that
will be effected when the bubble bursts although the impact will vary between
share prices which will lose value more quickly and to a greater extent than
houses because of their intrinsic value. To develop our understanding of this
problem we will need to define savings as assets whose nominal value is
protected and investments as assets whose nominal value is at risk.
The current bubble started to inflate as Central Banks
around the world reacted to the financial crisis which developed rapidly
through 2007/8/9. Almost without exception Central Banks started to reduce
their base interest rate to unprecedentedly low levels in order to offset the
threat of a deflation in average prices and a depression in their respective
real economies.
The bubble was slow to develop as people perceived of these
low rates as temporary emergency rates that would soon return to "normal"
levels. Being normalised in the UK meant returning from 0.5% to 5%ish. However
as the years have gone by so the perception has changed and is changing to one
of a feeling that the official bank rate is likely to remain at its current
level into the foreseeable future. This is the same in all the other major
economies including the USA and the Eurozone.
This means that the bubble in
asset prices is being fuelled by people moving out of fixed nominal savings
contracts into higher risk investments. There are two reasons for this: firstly
the dividends on shares are better, even with increased risk, than the return
on savings and, secondly because a capital gain will increase the rewards over
and above the dividend return. In addition to this people, seeing share prices
rising alongside very cheap loan availability, will be attracted to borrow and
buy shares. This last point will ensure the bubble bursts rather than slowly
deflates.
At this point some simple maths may be helpful if we look at
savings rates and investment returns including capital gains. Going back a few
years let us remember that a normal rate of return on savings was about 4% and,
given a risk premium, the rate of return on investments was about 6%. At that
time share prices would reflect a higher dividend yield, say 6%. Following this
let us suppose that the Central Bank base rate is reduced and savings rates
fall to 2% and this is perceived as a long term rate going forward. Share
prices will gradually rise until dividends are 2% plus a risk premium. For sake
of argument a 3% average return on shares will mean that stock market
valuations will have doubled.
Now let us look at the reverse of this position given the
situation in the UK. On March 5th 2009 the Bank of England lowered
bank rate to 0.5%. Initially this was seen as a temporary or emergency rate
that would soon be normalised. Because of this it did not have a significant
effect on people`s permanent perception of saving rates, investment returns and
capital values. However as time has gone by and savings rates have continued to
fall close to zero so people holding savings have been attracted to invest in
equities.
This increase in demand for equities has caused their price to rise
and the dividend yield to fall. Suppose the best savings rates are currently a
little over 1% then people will expect dividend yields to be over 2%, but they
may lose sight of this if they are overcome by capital gains and only see share
prices continuing to rise.
We are now travelling well into bubble territory. Not only
are the dividend and capital gains encouraging people to move into shares so
other people are being encouraged to add fuel to the fire by borrowing to
invest; something that was rife just before the Wall Street Crash.
No sensible person considers a Bank rate of 0.5% as a normal
sustainable rate and at some point in the future interest rates on savings will
begin to rise unofficially if not officially. The result will be that share
prices will start to fall, capital losses will offset dividend yields, the professionals
will be the first ones into cash followed sometime later by amateur investors.
Stock markets will rapidly lose value to reflect higher savings rates and the
bubble will have burst and even worse this will be happening all around the
world.
