What Does The Future Hold?

So what is the future for markets and are they still vulnerable to suffer from asset price bubbles? It would normally be safe to assume that after suffering so much pain and coming close to the collapse of the entire banking system investors would exercise more caution in the future. However history does not prove this to be the case. The DOTCOM bubble burst in the early 2000’s and investors lost much of their savings and pensions however the lure of quick, large and easy profits soon eradicated any thoughts of caution or rationality and once again we ended with another, even bigger bubble.

Looking toward the future many commentators and investors are already pointing towards the Gold price as being too high and remarking that this will soon burst. The widely known investor George Soros has stated many times that he believes the Gold price will correct soon and has even referred to it as the ‘ultimate bubble’. He has also reduced his holdings by 99 per cent! (See video below) Others have pointed to the entire Chinese economy as being a bubble. They claim that it is obviously not sustainable for the Chinese economy to continue with double digit levels of GDP growth and for their Government to keep the Renminbi, pegged at an artificially low level against the dollar. What will be the wider global consequences if the Chinese economy was to retract?

My concluding thoughts are that The Fed ultimately has responsibility for the wider economic stability of the system and it therefore has a duty to act if it feels any market could potentially damage the economy. The idea presented by the Efficient Market Hypothesis that investors make rational decisions based on all the information available is no longer valid. We all know from our daily lives that human beings don’t always make rational decisions and can be influenced by their background or others around them. However the argument that The Fed cannot prevent every increase in prices without damaging the economy is still valid and therefore presents the question ‘When should The Fed step in and when should they let the market run its course?’

I believe that the answer lies in whether or not the bubble is presenting a real threat to the wider economy. The housing bubble in the US was so dangerous because of the high levels of debt financing involved and the fact that in many cases either the underlying asset or the borrower was of low quality. However in the case of other bubbles such as the DOTCOM bubble in early 00’s or the potential bubble growing in the Gold market The Fed should let the market run its course as these do not present the same high level of risk to the economy. In these markets investors are mostly self-funded or use funds from their pensions and therefore run the risks and will ultimately face the consequences alone.

Are bubbles a preventable illness?

Throughout history ,financial crises often follow these asset price bubbles. The Fed ultimately has responsibility for maintaining the stability of the US economy, so should the central bank and government do more to prevent these bubbles from developing in the first place? In my previous post I outlined how I felt The Fed contributed to the housing bubble and I also touched on how political influence may make it difficult fopr The Fed to completely cut off any increase in asset prices. However I do believe that they could have acted differently in order to limit the boom in housing prices.

The first step (possibly the most simple and most important) would have been to acknowledge the existence of a bubble in the first place and at a much earlier stage. Working along with both the Federal Government and mortgage lenders they could have informed and educated the general population on the dangers associated with the bubble which was developing. They could have encouraged more caution on the part of both lenders and borrowers which may have somewhat curtailed the problem of irrational behaviour I discussed earlier.    

Secondly, as the regulator they could have issued specific regulations with regard to subprime lending. They could have specifically targeted the mortgage lending industry with increased standards which would have to have been met by borrowers. More specifically, dangerous products such as greater than 100 per cent mortgages could have been abolished and higher standards with regards to borrower suitability could have been introduced. Regulation could also have been used to influence the assets held by banks and their over all exposure to property backed assets could have been reduced.

Finally, and possibly the most extreme measure would have been to increase interest rates in an attempt to directly reduce mortgage borrowing. This step would have reduced to availability of funds to banks and therefore to individuals. This step however may also have had negative effects for the wider economy such as small businesses and therefore would have been unpopular with the Federal Government and the population.

On his blog (available here) Professor John Turner of Queens University Belfast recently posted a video of Adam Posen from the Monetary Policy Committee at The Bank of England discussing asset price bubbles. Mr Posen argues that it is not possible to tell the difference between a bull market and an asset price bubble before the bubble bursts and therefore central banks are not able to take pre-emptive action to deflate a bubble as this would damage real growth in the economy.

My own opinion at this stage is that for both practical and political reasons it can be difficult for central banks to prevent asset price bubbles, none the less, they should be extremely careful not to encourage bubbles to develop in the first place!