Spotting the Next Economic Bubble

It’s difficult to predict what the next bubble will be, or when it will develop. But there are “early warning signs,” that, like the tiny crocus flowers that push through snow cover in early spring, point to changes ahead. One of the most important harbingers is an abundance of liquidity.

Markets are driven, in a very real way, by liquidity — a high-toned word for plain old cash. The song lyric from Cabaret, “Money makes the world go ’round,” has never been more true than in recent years. From the supply of money flows credit decisions that grease the wheels, not only in financial markets but economies in general.

In simple terms, central banks and governments control the supply of money and credit through two “spigots:” monetary and fiscal policy. Central banks control money supply by managing short-term interest rates. Governments do it using taxation and public spending.

To balance economic growth, one institution may work independent of the other. That is, one spigot may be open while the other is closed. For example, a government might increase taxes, while a central bank reduces interest rates to mitigate the impact of those taxes.

However, to slow down an overheated economy, both interest rates and taxes oft en move higher, to reduce the money supply. To stimulate growth, on the other hand, both spigots can be open. You will then see the government lower taxes and the central banks lowering interest rates.

Our objective here is not to turn you into an economist, of course, but to give you a simple way to see how the ebb and flow of money is controlled, as central banks and governments turn the taps on and off.

While banks and governments control the supply, in a free market economy the financial markets determine the direction. That means available liquidity (i.e., cash) will flow into investments that the market considers will benefit most from the economic environment.

Watch the needle on liquidity

Problems surface, though, when there is an excess of liquidity — it can spill over and drive the value of investments way beyond their fundamental values, to irrational levels. At the other end of the spectrum, too little liquidity can push investments well below their fundamental value.

The key to spotting potential bubbles, then, is to:

• Monitor central banks and government action to see how
tight or loose the two spigots are that control money supply.
• Try to foresee where the liquidity is flowing. Is it moving away from stocks to bonds, for example, or vice versa? Is all the money going into real estate, or into commodities (oil futures, for example, are at about $120 per barrel now).

An excess of liquidity creates excess demand for an asset, which pushes prices higher, reflecting lower return expectations among irrational participants (who think of themselves as investors, when they are really speculating).

Consumers fuel the liquidity fire, too

Ample availability of cheap and easy credit turns consumers into spendthrift s in record levels, enticing homeowners to tap into the available cash in their home equities and credit cards, and use it to sustain their way of life. Evidence: By the second half of 2005, financial obligations as a percentage of household income stood at 16 percent, nearly the highest on record. At the same time, savings as a percentage of disposable income sank to zero, the second lowest since the Great Depression.

High-octane liquidity sparks liberal and rapid credit creation, which in turn inflates asset values beyond rational norms. The result? An uncontrollable, global-scale liquidity flow that pushes asset values, particularly real estate, commodities and emerging market debt to over-rich levels.

It is liquidity overflow that fuels all of this activity, and turns everyday people into unsuspecting speculators, if not gamblers. People looking to “make a killing” often dive into risky assets like emerging countries’ stocks and bonds, real-estate backed debt, fine art, private equity funds — and sophisticated investment contracts even bankers can’t understand.

The difference is that experienced speculators will walk away when a miniscule risk premium signals low compensation for high risk. The Wall Street Journal explains it well: “…as the price of an asset rises, the income it throws off — a stock’s dividend, a bond’s coupon, a building’s rent — automatically declines as a percentage of the asset’s value. This means investors are demanding less compensation than usual for taking on the risk inherent in owning the assets.”

In plain language, the risk premium needs to be high enough to compensate for the possibility that you will not get the return you expect (and might even lose your principal). What happens in bubbles, as we have seen in evidence dating back to the 17th century, is that sky-high prices, like the mythical Icarus, fly too close to the sun and inevitably fall back to earth.