Just as the capital markets were overlooked by the mainstream academia and policymakers in the build-up of the sub-prime mortgage bubble, it may be that the same mistake is being repeated with the present bull run in equity markets across the world. Whereas every major indicator of economic growth show at best the initial stirrings of a recovery, the financial markets have been galloping on an upward incline, threatening to inflate another asset bubble.
It is clear that even as the credit markets remain constrained despite the banking sector being awash with liquidity, the excess liquidity is finding its way into the financial markets. The unconventional monetary policy actions like quantitative easing, dilution of lending standards, government debt guarantees, etc, have had the effect of creating a "wealth effect" among financial institutions that has in turn found its outlet in the capital markets.
In an excellent article in FT, Wolfgang Munchau points to two equity market metrics - Cape (invented by Robert Shiller), which stands for the cyclically adjusted price/earnings ratio and measures the 10-year moving average of the inflation-adjusted p/e ratio, and Tobin Q, a metric of market capitalisation divided by net worth - both of which agree that US equity markets are overvalued by some 35-40%. Further, in another indication of froth returning to the financial markets, home prices have been making a surprising rebound, even as foreclosures show no signs of easing off.
Munchau, like a growing number of economists, attribute this asset market rally to the cheap money policy being pursued by the Fed to support the recession-hit and slowly recovering economy. The Fed has been unwilling to raise rates for fear of nipping out the nascent "green shoots" of economic recovery. He therefore predicts a period of dangerous tight-rope walking and inevitable economic instability,
"Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control...
Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages. Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation."
All this comes even as an intense debate rages on about the inadequacy of modern macroeconomic models to account for capital market events in predicting or explaining macroeconomic events and outcomes. Further, the events of the last eighteen months have spotlighted attention on the need for Central Banks to look beyond mere aggregate price levels and focus on financial asset price trends while formulating monetary policy. Financial market stability has assumed equal importance alongside economic stability in interest rate decisions. And it now appears that both these objective may be in conflict at this point in time, when the economy is poised on recovery path after a deep recession and the financial markets indicate a bubble blowing up.
The difficulty with raising interest rates leaves the Central Banks to focus attention on rolling back some of the uncoventional policy responses which may have had the effect of generating the "wealth effect" among financial isntitutions and channeling funds into the capital markets. However, this is a difficult balancing act and would require judgement calls that would require making trade-offs between the relative impacts on the real economy and financial markets. Apart from adversely affecting economic activity, any event (not just direct rate hikes) that would put an upward pressure on interest rates now could devastate the weak balance sheets of a majority of the banks and a large portion of mortgages, both of whom are effectively surviving by clutching on to the sliver of hope provided by the ultra-low interest rates.
However, many emerging economies like India, whose banking sectors have been relatively unaffected by housing mortgage and derivative based on them, and who are also experiencing the same twin dilemma of containing an equity market bubble without nipping off the first signs of economic recovery, may have some room to manouver with their monetary policy. They can rein in the non-interest rate instruments of expansionary policy without adversely affecting the financial markets. Thus the Reserve Bnak of India could slowly drain off the excess liquidity by raising the various mandatory provisions like the CRR and SLR, so as to shrink the excess bank reserves which are presently finding its way into the capital markets, either directly or indirectly.
It is in this context that aggressive and intrusive financial market regulation to prevent the build up of firm-specific and systemic risks assumes great significance. It is now very clear that a massive resource mis-allocation is underway into the capital markets. The conventional policy instruments to control such situations have become ineffectual due to the specific economic conditions being faced. In the circumstances, there is no alternative but for the regulators to step in and exert the regulatory hand to contain the unrestrained build-up of asset bubbles. Unfortunately, governments across the world do not appear to have the stomach for any such adventurism. The lessons of the past few months appear not to have been learnt.
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