Escaping the Bubble Economy

Genuine Wealth

troyMediaRobert McGarvey

Dec. 1, 2013

Champagne corks are popping on Wall Street these days. Investors in the United States have seen near record year-on-year gains. The DOW is up 22.8%, the S&P 500 27% and the Nasdaq is cruising along at 35% gains.  Although Canadian markets are performing admirably, up 7% this year, they pale in comparison to their American counterparts.

US price to earnings (P/E) ratios are approaching record highs. Admittedly, there have been higher P/E ratios in the past, but you have to go back to ’29 Crash and the 2000 dotcom bubble to find them.

Although many fear that the markets are oversold, the word from financial pundits is ‘there’s more to come’.  They point out that corporate profits are at record levels relative to GDP, primarily due to outsourcing, aggressive cost cutting and other savings.

Of course, stocks are not the only bubble that commentators are worried about. In Canada the general consensus is that our housing market is either in or approaching bubble territory as well.

Regrettably, it is not sound economic fundamentals that are driving accelerated gains in these asset classes. Houses and stock markets are rising faster than the underlying economy because of politics, deliberate policy choices.

In particular both these markets are being driven by the near zero interest rate policies put in place in developed economies and a policy of Quantitative Easing in the US.

Why is this happening?

The reality is, the world is drowning in debt. U.S. sovereign debt, for example, is $16.5 trillion, having recently skyrocketed past 100% of GDP. Meanwhile, according to my colleague, wellbeing economist Mark Anielski, the total indebtedness of Americans, considering all levels of government is a staggering $58.8 Trillion.

A predictable consequence of this very low interest rate policy is the collapse of private sector demand for interest-bearing government bonds, in particular for United States Treasuries, the lynchpin of the global bond markets.

But, with debts to pay governments need to sell their bonds. In order to overcome the dilemma of fewer than expected buyers, the US government instituted a policy of Quantitative Easing (QE).

What is Quantitative Easing? It’s a process whereby the United States Federal Reserve prints the money it needs to purchase the bulk of bonds issued by the Treasury Department; thereby ‘easing’ market demand for Treasuries. Meanwhile government bonds get sold and keep the wheels of government turning. If this sounds like funny money to you and policy desperation; you’re right, it is.

There is a simple rational for all this. If interest rates were to return to historic norms (8-10%), the compounding interest on debt would swamp the budgets of every developed nation, Canada included. In the US a return to normal rates would be catastrophic, interest on debt becoming – at a stroke – larger than the Defense, Medicaid and Social Security budgets combined.

Is there a way out of this frightening dilemma? Well, throughout history debtors of all kinds (including governments) have become trapped in compounding interest burdens, which triggered crises and eventually defaults when debtors could not or would not support their debts.

Occasionally, where cooler heads prevailed, alternatives to catastrophic default were implemented. The means varied from politically orchestrated debt jubilees to debt for equity swaps and other means of escaping the iron laws of exponential growth on compounding interest.

Regrettably, none of these options are being considered at the moment. The big question puzzling mainstream economists is, why low interest rates are creating assets bubbles and not stimulating growth in the economy?

Truth is we’re misdirecting capital today. We have bubbles in property and in tradable equities because these traditional assets are the only assets banks and other financial intermediaries recognize. As a result, capital flows into property and stock markets almost by default. Unfortunately, starved of capital, the rest of the economy is not growing fast enough to support the rising housing and stock markets – creating bubbles.

The value creation engine in our economy is migrating, moving rapidly into new asset forms that need institutional support of all kinds. Oxygenating the productive heart of our intangible economy means building a new circulatory system for modern capitalism. If we are to avoid disaster, government policy makers, accountants, bankers and other financiers need to play a positive role in making this new reality happen.

Doing so would open the financial floodgates electrifying the economy, lifting the economy out of the doldrums and helping us all escape the perils of debt slavery.