Based on both recent history and mainstream economic theory the past few years should not have been possible. When you cut interest rates to near-zero, run deficits of 10% of GDP and buy up every government bond in sight with newly created currency, you get a boom, end of story. That’s just the way capitalism works.
But this time was different. After four years of QE and ZIRP and all the other easy-money acronyms, we entered the month of May with Europe in a deepening recession and the US recovery petering out.
The culprit? The one piece of the puzzle that governments can’t control: the velocity of money. This is simply a measure of how quickly holders of currency, i.e., banks, consumers, businesses, hand their currency off to someone else. The faster and more frequent the hand-offs, the more stuff gets bought and the more robustly an economy grows. But after their 2009 near-death experience, the world’s banks have been in no mood to lend. Instead, they’ve been sticking all the new currency their governments have been giving them under the proverbial mattress. This reluctance to lend means record low money velocity and little or no economic growth.
But in just the past month something fundamental has changed. US home sales and prices have accelerated, with prices returning to 2006 levels in some markets and bidding wars, flippers and interest-only mortgages once again becoming common. Stock prices pierced old records and then spiked rather than corrected. Suddenly we’re back in an asset-driven boom.
But it’s a boom with a twist because it coincides with unprecedented amounts of “excess reserves” in the banking system. This is the raw material for new loans, and banks across the country are worrying that they’re missing the boat by remaining in cash. Marginal mortgage applicants now look a lot more attractive because their collateral is appreciating. Private businesses, judged by the share prices of their publicly-traded peers, are becoming more valuable and hence more creditworthy. Families with rising stock portfolios and appreciating houses suddenly look like better bets for car loans.
So what happens if a tidal wave of bank reserves are suddenly converted to business and consumer loans at a time when asset markets are already overheated? Maybe the fabled crack-up boom of Austrian economics. A couple of weeks ago Daily Reckoning addressed this issue in an article that quoted Ludwig von Mises’ famous definition of a crack-up boom:
This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.
It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.
So how close are we to the point where “finally, the masses wake up?” Hard to say. Stocks and houses are back at previous-bubble levels and there’s even talk of a shortage of government bonds. And based on the excited emails pouring in from people who, after a decade of bad returns have seen their aggressive growth funds rise by 25% in a quarter and are feeling like geniuses, animal spirits are back and happy. All while bank lending has barely started to ramp up. It’s safe to assume that banks getting into the game would heat the markets up even more.
How would today’s financial system handle the resulting volatility? Prudent Bear’s Doug Noland addresses this in his most recent Credit Bubble Bulletin:
I don’t mean to imply that today’s environment is comparable to 1999. The U.S. economy was sounder in 1999 – and the global economy was a whole lot more stable. Global imbalances in 1999 were insignificant compared to the present. The U.S. economic and Credit systems had yet to be degraded by a doubling of mortgage debt and a massive misallocation of resources. The federal government hadn’t doubled its debt load in four years. Europe had not yet terribly impaired itself with a decade of runaway non-productive debt growth. China and the “developing” economies had not yet succumbed to historic Credit booms, overinvestment and economic maladjustment. Central banks hadn’t yet resorted to really dangerous measures.
The implication: This world, levered to the hilt in response to the policy mistakes and financial crises of the past few decades, is more complex and fragile than the systems that (barely) survived the bursting of the tech stock and housing bubbles. So this bubble and its aftermath might be a whole different animal.