Manas Chakravarty: The global bubble economy

We could be sitting on top of the biggest bubble in history

The Sensex has broken all records, foreign institutional investors are pouring in money into the market and fund managers all over the world are mesmerised by the India story.

Oil prices have fallen, corporate earnings continue to be healthy, commodity prices are holding up and companies are planning to set up new capacities, which is likely to set off an investment boom. Things could scarcely get better.

A gigantic bubble

And yet, not everybody is happy. Economists have for long been pointing to severe "imbalances" in the global economy, which is a polite way of saying that Americans live far beyond their means, importing far more than they export, thus running up a huge current account deficit.

The US has to attract capital of nearly $3 billion a day to finance this deficit, capital that Asian central banks have so far been more than willing to lend.

People have been fretting for a long time that this American dependence on the kindness of strangers could be dangerous, because Asian central banks lose a lot of money by putting their dollars into low-yielding US treasury bills, and they could one day decide that they have had enough.

That could lead to financial Armageddon, with bond yields rising rapidly in the US markets, sharply enough to puncture the huge mortgage debt bubble built up there. The American consumer would collapse, and with her, the US demand for goods and services from the rest of the world.

No wonder an International Monetary Fund (IMF) report described the deficit as "perilous" in the long run, posing "significant risks" to the rest of the world.

Thankfully, the US has been running up bigger and bigger deficits for years and yet there are no signs of diminished Asian appetite for dollar assets.

That has led optimists to declare that the present arrangement suits both parties. The savings-short US economy benefits from the low interest rates caused by Asian investment in the US, enabling household debt to expand and financing US imports of Asian goods. For Asian countries, the exports keep factories humming and workers employed.

The problem is that this arrangement has been deliberately helped along by lax monetary and fiscal policy in the US. The flood of liquidity has spread across the world, raising asset prices everywhere.

In many countries, real estate prices have moved up sharply. In China, export surpluses were used to fund massive infrastructure investment, while property prices in the coastal cities rose sharply.

The building boom, in turn, led to rising prices for commodities and oil. And all these assets have been driven higher by speculators who borrow money at negative real interest rates. In other words, today's high asset prices are the result of a gigantic bubble in the global economy.

Blowing serial bubbles

Foremost among the proponents of the bubble theory have been the economists at investment bank Morgan Stanley, with Stephen Roach, its chief economist, accusing US Fed Chief Alan Greenspan of being a serial bubble blower.

Morgan Stanley's chief economist for the Asia-Pacific region, Andy Xie, was in India recently and he drew a fascinating picture of how the Japanese real estate and stock market bubble in the late 1980s, the Asian crisis, the tech bubble in the US and the current US housing and Chinese investment bubbles were all related to each other.

It all started in 1985, when the US was fast becoming uncompetitive against Japan. The Plaza Accord arranged for a rapid depreciation of the dollar against the yen, and the rising yen affected the Japanese economy severely.

Japan had to keep interest rates low to support the dollar, and the result was a huge asset bubble that pushed up stock and property prices to extraordinary heights. When interest rates went up, the bubble collapsed, sending Japan into more than a decade of stagnation.

A by-product of the rising yen was the shift to south-east Asia of much of Japanese investment. Loose monetary policy in Japan also led to money spilling over to east and south-east Asia. At the same time, international portfolio flows also found their way there.

The result was the Asian investment bubble, which finally burst in 1997. The money fled Asia, only to fuel a new bubble, the New Economy or tech bubble in the US. According to this view, the New Economy was only a convenient excuse "" if the Internet hadn't come along the bubble would have occurred in some other asset class.

Richard Duncan, author of The Dollar Crisis: Causes, Consequences, Cures believes that the origins of the serial bubble economy can be found much earlier than the Plaza Accord "" he traces it back to the days when the US abandoned the Bretton Woods agreement.

The change in the US' status from a creditor to a debtor nation also led to the creation of bubbles, as the build up of foreign exchange reserves in exporting countries led to expanding money supply in those countries, and cheap money fuelled asset bubbles.

There are other bubble stories. Some start with the build up of surpluses in the Opec (Organisation of Petroleum Exporting Countries) in the 1970s, surpluses that were recycled into petrodollars, or dollar holdings by Opec with US banks.

That created the Latin American lending binge, followed by the "lost decade" for these countries as US interest rates rose and they couldn't repay the loans.

Reasons for the bubble

But why do these bubbles arise? One view is that they started when the financial system was finally de-linked from gold after the collapse of Bretton Woods. All that the US has to do to pay its debts, for instance, is to print dollars, because the dollar is the world's reserve currency.

Xie says that two factors contributed to the "too much money" syndrome. One was the winding down of post-war reconstruction in Europe and Japan, and the second was the end of the Cold War.

Both these factors led to less money being needed for investment and armaments, and the money freed up went into speculation. De-industrialisation in the advanced nations also helped, as it released capital that went into the financial system.

Other explanations point to the build-up in debt worldwide. One way to increase the size of the market is to increase lending to consumers. That's true not only for the finance you get when you buy a car, but also, at another level, to the investment in US bonds by Asian central banks.

You also have the Marxist explanations, which rely on the fact that with a skewed distribution of income, supply does not automatically create its own demand. One way out of this problem is to make goods cheaper, which explains the migration of manufacturing to China and services to India.

Another is to find new markets. A third way is to expand consumer debt. A fourth is to abandon manufacturing and use the money instead for speculation "" this explains the growth of derivatives, which Warren Buffet says are financial weapons of mass destruction.

Whatever the explanation, the global economy has been moving from one bubble to the next, and the bubble has grown so big that it will cause widespread distress if it pops.

The brighter side of bubbles

But bubbles also have plenty of positive functions "" they wouldn't have lasted so long otherwise. One, they are a way out, albeit a temporary one, from the fundamental imbalance of a US economy that does not save, and an Asian economy that does not consume.

Two, they are good for financial players, who thrive on volatility. Three, by increasing asset prices and creating a positive wealth effect, they can stimulate economic growth. They can also lead to investment binges, like the current Chinese investment bubble.

The problem with Indian bubbles created by the rush of FII money is that all of it goes to the stockmarket. When the bubble collapses, the money flows out and the market falls. In China, on the other hand, the government loses no time in raising as much money as it can whenever the market rallies.

Local governments float investment companies in the market, which use the money they raise to fund infrastructure. All through the recent market rally, Chinese companies have been going in for initial public offerings (IPOs), and IPOs from China in overseas markets this year will probably be around $10 billion.

Indian firms need to follow suit "" with the hype about India reaching fever pitch, this is a fund-raising opportunity they simply cannot afford to ignore. The time to raise money is not when you need it, but when conditions are favourable.

As for the government, it should lose no time in getting its infrastructure companies listed and raise billions of dollars from FIIs only too willing to buy into the India growth story.

True, they may have to wait years before they see returns, as they have done in China, but that's their problem. When the bubble collapses, at least the infrastructure they have built will remain in the country.