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All Signs Point to Bubble

In its Jan. 10 issue, Business Week carried an article, A Gold Medal for the Fed's Inflation Fighters, from Glenn Hubbard, dean of Columbia Business School and former chief of the president's Council of Economic Advisers. The key point of this article is that "by holding inflation down, the Fed has boosted the economy." We mention this article because it is highly typical of the prevailing systematic disinformation about the U.S. economy.

Given a U.S. inflation rate of 3.3% during 2004, any talk of "ridding the U.S. economy of inflation" is, first of all, grossly misplaced. Even more absurd is the further assumption that the Federal Reserve has distinguished itself as a great inflation fighter.

In actual fact, in the past few years, the Greenspan Fed has systematically and deliberately fostered parabolic credit and financial excess with the explicit purpose of inflating asset prices. What manifestly is duping most people is the fact that the bulk of the credit excess poured into asset prices and the soaring trade deficit, rather than into the CPI, as had been usual.

As we have repeatedly stressed, speaking of inflation requires a distinction between cause and effects. It ordinarily has one and the same cause: excessive creation of money and credit. But its impact on the economy and its price system depends entirely on the specific purposes for which the borrowed money is used. Therefore, its effects may differ immensely.

Principally, credit excess may find three different outlets: first, rising prices of goods and services; second, rising prices of financial and tangible assets; and third, a rising trade deficit.

The conventional focus is exclusively on the first outlet: that is, on the movement of consumer prices, popularly called CPI in America. Amazingly, even most experts flatly deny a causal connection between a rampant credit expansion, rising asset prices and a rising trade deficit. The rampant inflation in U.S. stock and house prices is actually hailed as "wealth creation."

Historically, consumer price inflation has, indeed, been the regular key feature of credit excess. But this pattern began to change drastically in the course of the 1980s. For the first time, protracted, exceptionally sharp increases in stock and real estate prices occurred in various countries, while price increases for goods and services remained moderate.

At first, there was little inclination to see in soaring asset prices a feature of inflation, even though all countries concerned showed a simultaneous surge in money and credit growth. It irritated many experts that this monetary explosion did not show in higher prices for goods and labor, as it had done in past booms. In the late 1980s, Japan had double-digit money, credit growth and soaring asset prices, yet virtually stable consumer and producer prices.

For years, this strange coincidence of soaring asset inflation and simultaneous moderate consumer price inflation was hailed as a sign of economic health and dynamism. It has long been one of Mr. Greenspan's favorite arguments that this unusual coincidence proved the existence of a "new paradigm" economy.

While stock prices have recovered from their lows in 2001, in general, their gains during 2004 were very limited. Instead, a developing property bubble has gone global. Full-blown housing bubbles with double-digit annual price increases now exist in many countries, for an obvious cause. Ultra-low interest rates introduced by central banks to fight threatening recession have triggered an explosion in borrowing for house purchases in many countries.

Observing this, it must be stressed at the outset that from a macro perspective, the crucial issue is not an asset price bubble per se. The key question is whether and to what extent asset owners convert the asset appreciation into higher borrowing and spending. Asset bubbles as such constitute little more than a temporary economic nuisance.

In France, too, where we live, house prices have soared at double-digit rates. But the key feature of a bubble economy - that is, the run of house owners for equity extraction, as in the United States and Britain - is completely missing, even though variable mortgage rates are at a historical low of 3.25%. Remarkably, nobody in France talks of "wealth creation." France certainly has a house price bubble, but it does not have a "bubble economy" in the sense that the rising house prices are used to boost consumer borrowing and spending for other purposes.

In the late 1990s, the U.S. stock market bubble went global. The same has happened in the last few years to the property price bubble. According to reports, full-blown housing bubbles currently exist in many countries around the world. As explained, their common cause is obvious: Ultra-loose monetary policy and ultra-low interest rates. In due time, sharply rising house prices added to the interest incentive.

Under these monetary conditions, it made sense to buy a house.

But to repeat, the pivotal hallmark of a "bubble economy" is that the ballooning asset prices are widely used as collateral for a general consumer borrowing and spending binge. In the United States, mortgage borrowing by households during the first half of the 1990s increased by an annual average of $168 billion. This accelerated in the decade's second half to $296.9 billion. But after 2000, it virtually exploded to an average annual growth rate of $615 billion.

It is undisputed that the greater part of the escalating mortgage borrowing in the United States was for purposes other than house purchases. In short, it boosted consumption as a share of GDP at the expense of business investment and the trade balance. That is, it radically changed the U.S. economy's pattern of growth - actually an unsustainable pattern of growth.

Yet America's consensus, amongst it Mr. Greenspan and the Fed, categorically refuse to see any proof of a "bubble economy." A recently published survey article by the St. Louis Federal Reserve - Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms - made a most amazing statement in its conclusion: "We find little indication that booms were caused by excessive growth of money and credit, though 19th-century booms tended to occur during periods of monetary expansion. The view that monetary authorities can cause asset market speculation by failing to control the use of credit has been largely discarded."

To quote a commentator: "The complacency of the central banking fraternity and their academic standard-bearers is a wonder to behold."


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