In late 2008, at a meeting with academics at the London School of Economics, Queen Elizabeth II asked why no one seemed to have anticipated the world’s worst financial crisis in the postwar period. The so-called Great Recession, which had begun in late 2008 and would run until mid-2009, was set off by the sudden collapse of sky-high prices for housing and other assets — something that is obvious in retrospect but that, nevertheless, no one seemed to see coming.
Are we about to make the same mistake? All too likely, yes. Certainly, the American economy is doing well, and emerging economies are picking up steam. But global asset prices are once again rising rapidly above their underlying value — in other words, they are in a bubble. Considering the virtual silence among economists about the danger they pose, one has to wonder whether in a year or two, when those bubbles eventually burst, the queen will not be asking the same sort of question.
This silence is all the more surprising considering how much more pervasive bubbles are today than they were 10 years ago. While in 2008 bubbles were largely confined to the American housing and credit markets, they are now to be found in almost every corner of the world economy.
As the former Federal Reserve chairman Alan Greenspan recently warned, years of highly unorthodox monetary policy by the world’s major central banks has created a global government bond bubble, with long-term interest rates plumbing historically low levels.
He might have added that this bubble has hardly been confined to the sovereign bond market. Indeed, stock values are at lofty heights that have been reached only three times in the last century. At the same time, housing bubbles are all too evident in countries like Australia, Britain, Canada and China, while interest rates have been driven down to unusually low levels for high-yield debt and emerging-market corporate debt.
One reason for fearing that these bubbles might soon start bursting is that the years of low interest rates and avid central bank government bond buying that spawned the bubbles now appear to be drawing to an end.
The Federal Reserve has already started to raise interest rates — on Wednesday it hiked the benchmark rate by a quarter of a percentage point — and has announced a schedule for reducing the mammoth amount of government securities it holds. At the same time, with the European and Japanese economic recoveries picking up pace, both the European Central Bank and the Bank of Japan are hinting that they are likely to soon follow the Fed’s lead in tightening monetary policy by raising rates.
Other reasons for fearing that the bubbles might soon start bursting are the fault lines in a number of major economies. Italy has both a serious public debt problem and a shaky banking system. Brazil is experiencing political turmoil while its public finances are on a clearly unsustainable path. China has a housing and credit-market bubble that dwarfs the one in the United States at the start of this century. And both Brazil and Italy will be holding contested parliamentary elections next year.
This is not to mention the economic dislocation that could result from a termination of the North American Free Trade Agreement, or from the accentuation of other protectionist tendencies, whether by the United States or by another big country. Nor is it to mention the risk that events in the Korean Peninsula could spin out of control.
Economic policymakers seem to have lulled themselves into a false sense of security by trusting the stricter bank regulations put in place after the collapse of Lehman Brothers in 2008. They seem to be turning a blind eye to the dominant role that so-called shadow banks (hedge funds, private equity funds, large money market funds and pension funds) play in the American financial system now. Unlike the banks that were covered by the Dodd-Frank regulations, these institutions are lightly regulated — but, as we painfully learned in 1998 when the hedge fund Long-Term Capital Management had to be bailed out, are subject to deposit runs just like banks.
It is too late for policymakers to do much to prevent bubbles from forming. However, it’s not too early for them to start thinking about how to respond in a manner that might free us from the boom-bust cycles that we seem to be experiencing every 10 years. They could, for example, create a program that in a severe downturn would give every citizen a cash grant to be spent at their discretion, what Milton Friedman called “helicopter money.”
It’s unclear, however, whether the world’s largest economy can take the lead this time. The Trump administration’s budget-busting tax cuts risk overheating markets even further and limiting the government’s ability to respond when the bubbles pop. This heightens the risk that when the bubbles burst, we’ll be forced to rely yet again on artificially low interest rates, which will set us up yet again for another boom-bust cycle.
Desmond Lachman, a resident fellow at the American Enterprise Institute, is a former deputy director in the International Monetary Fund’s policy development department and a former economic strategist at Salomon Smith Barney.