Stories to Frighten Children

MedalCommentators like to exclaim about how much “market cap was lost” or “wealth was destroyed” by the latest drop in price. In a market crash, however, the drop does not destroy wealth. It merely reveals the true level of wealth. Destruction happens on the way up, as irrational exuberance leads to poor investments.

Watching the numbers on Wall Street, it’s easy to forget that investments ultimately are made in earning assets like shops, labs, and factories. It’s during the bubble phase that wealth is destroyed, by funding investments that never pay off.

The EU has had to deal with two crises … The first was obviously the global financial crisis, caused by major falls in asset values. – Douglas Flint, remarks to House of Lords October 2014

We were reminded of this popular misconception when we read it recently in Douglas Flint’s testimony before the House of Lords. This statement is an oversimplification, to put it politely. “Major falls in asset classes” did not materialize out of nowhere.   Is there anyone in the House of Lords who accepts this account of the crisis? It seems scripted – for children, perhaps, or the CNBC cheerleaders.

Masaaki Shirakawa comes off as rather better informed, but still surprised (!) to discover asset price bubbles. In fairness, the Japanese bust was the first of its kind among developed economies in the postwar era.

We have to start by recognizing this odd reality of bubbles being accompanied by price stability, yet then followed by instability of the financial system, subsequently bringing about low growth and often inflation that is lower than desired. – Masaaki Shirakawa, remarks at BIS conference March 2014

Yes, this odd illusion of stability – like ice over a flowing river. He goes on to describe a central bank misled by consumer prices into “accommodating” an asset bubble, which in turn destabilizes the financial system. The ensuing low growth, we have to say, is the true trend rate.

Our purpose here is not to single out people, like Mr. Flint, who should know better. We are intrigued, however, by the long list of trained professionals who continue to be surprised by this well understood chain of events. This prescient article, subtitled “central banks should pay more attention to rising share and property prices,” is from 1999.

U.S. house prices have risen by nearly 25 percent over the past two years … but these increases, [Bernanke] said, “largely reflect strong economic fundamentals.”

This studied “surprise” is starting to wear thin. Have America’s central bankers purposely inflated bubbles and then lied about it? That seems a little extreme. Maybe there’s another explanation. Here is an iconoclastic way of looking at our American trendline:

Trendline

Maybe, without the tech bubble and the housing bubble, the S&P 500 would have run flat around 1,200. Raghuram Rajan has said that Western leaders are using credit to compensate for their citizens’ loss of purchasing power. They have a powerful incentive not to admit their economies are in decline. Boom and bust cycles, six or seven years long, are preferable to obvious stagnation – especially on an elections calendar.

If the Fed were not complicit in this deception, politicians would change the Fed. Consider Sen. Schumer’s famous “get to work, Mr. Chairman,” or this one from Sen. Gramm – mere weeks before the NASDAQ crash:

 “Don’t become so frightened by success that you throw wet blankets on a fire that isn’t burning.”

Central bankers aren’t stupid, and they aren’t independent. They know their political masters enjoy a rising stock market, and can easily escape blame for the inevitable crash – especially if the crash is inexplicable, and entirely unforeseen.

See also: America’s structural trap

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