We’re living in the everything bubble. It’s not just a tech bubble, a housing bubble, or a bond bubble, but all three and more. The big question is: what pops the bubble? And the answer might surprise you…
You see, when central banks meddle in the economy, they do so disproportionately in certain sectors. At least, the effects of their meddling are felt disproportionately by certain sectors.
Sometimes central bankers create a bubble in the stock market, like in 1999. Sometimes in the housing market, like in 2006. Sometimes in emerging markets, like in 1996.
The effects can also be geographically uneven. Sometimes the housing bubble is in Spain and Ireland, like in 2005, and sometimes in Germany, like in 2018. That’s despite the fact that these economies share the same euro and the same interest rate.
We call these bubbles ‘asset price inflation’ to reflect that it is central bank inflation flowing into sectors of the economy and bidding up prices there, not some sort of improvement, which justifies higher stock or house prices. So it is inflation, but it’s not consumer prices that are rising; it’s asset prices.
This is heresy to mainstream economics, by the way. In the central bankers’ world of so-called ‘money neutrality’, all prices are buoyed equally by inflation. After all, if money is devaluing, then money is devaluing against all things equally. It’s like pouring water into a bathtub — the level rises evenly.
But this ignores how money is devalued. And the disproportionate effects on different types of prices from that devaluation.
Sure, if you pour water into the bathtub, the water level rises equally. But your toes can still get burned while your shoulders are shivering. Unless you’re in a Japanese bathtub, but that’s a story for another day.
Investors who understand the uneven effects of central bank policy can use it to profit, and handsomely at that. Richard Cantillon did so, twice, by speculating on the boom and bust of the South Sea and Mississippi Bubbles.
Why mention him? Well, he also founded the field of economics while making his fortunes. Yes, an economist who put his money where his theory is and came out ahead too!
Cantillon’s thesis explained how central bank policies create and fuel bubbles in parts of the economy. That’s why the uneven effects of central bank policies bear his name today — they’re known as Cantillon Effects.
But how do central bank policies have an uneven impact?
Well, assets purchased with debt, such as property and sometimes stocks, benefit disproportionately from inflationary policies. Debt becomes cheaper at lower interest rates, and again as it gets inflated away during inflation.
That’s why central bank-created housing bubbles are so common — property is disproportionately purchased with debt and thereby disproportionately affected by central bank policy.
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But here’s the bit you need to focus on: As central bankers see it, when the Consumer Price Index isn’t picking up on the inflation that’s happening, because it’s happening in asset prices instead of consumer prices, then there isn’t any inflation. Not as far as central bankers are concerned.
Booming stocks, bonds, and property have nothing to do with them lowering interest rates and printing money. At least, it’s not their problem or responsibility. As long as the Consumer Price Index doesn’t reveal the extent to which money is being devalued, all is well in the inflationary world of the central bankers. That is the only inflation central bankers focus on.
This was their big mistake in the lead up to 2008. The idea that you couldn’t have a central bank inflated housing bubble in isolation. There was no significant consumer price inflation in the lead up to 2008, so the central bank’s policy of inflating a huge housing bubble was judged to be just fine.
To be clear, this is at least partially just an arbitrary statistical blunder. If house prices were included in measures of inflation, then suddenly central bankers would have to react to rising house prices by raising interest rates. And so they’d rein in housing bubbles before they form a bubble, let alone crash.
But, because house prices aren’t included in the central bankers’ definition of inflation, housing bubbles can run out of control without central bankers worrying about it. The elephant in the room is invisible if you’re looking hard enough at a manifest that doesn’t have a category for elephants.
There’s another angle, which amplifies the same problem.
Consumer prices are buffeted by all sorts of forces, not just inflation. If former isolationist economies like China suddenly come onto the world’s trading stage, just hypothetically speaking, of course, it has a huge effect on consumer prices globally. In the case of the ‘Made in China’ boom, our consumer prices should fall because the cost of manufacturing in China is cheap.
But if central bankers try to offset this with inflationary policies, and succeed, those prices don’t fall. The important thing to notice is that inflation, like all things, must be measured against what would’ve happened, not against nothing happening.
In other words, if prices would’ve fallen 20% over the course of a decade thanks to China, but central bank policy made them rise 20% instead; that means central bankers engineered inflationary effects of 40%. That’s a huge impact — a lot of hot water, which is about to burn your toes while you focus on your shivering shoulders.
Of course, any newsreader will tell you that, over the course of the decade, inflation was spot on target of around 2% per year, so there’s nothing to worry about. But the actual effect of the policy was a huge amount of inflationary pressure. It’s just that this was offset by deflationary forces, masking just how much inflationary pressure the central bank had to impose.
Why does this matter? Because, in trying to keep consumer prices going up at 2%, regardless of what supply and demand are trying to do to prices, central bankers mask the large housing and other asset price bubbles, which their inflationary pressure is creating.
To them, looking at the statistics, not much is happening as a result of their policies. And their policies aren’t having much effect. 2% inflation is plodding along just fine.
But, in trying to offset goods becoming cheaper, they are actually implementing hugely impactful policies. Impacts that can show up in asset price bubbles, as the housing bubbles and busts showed. Asset price bubbles are invisible to central bankers focusing only on 2% inflation in the Consumer Price Index.
This is the mechanics of how bubbles are formed, without central bankers realising it, let alone the fact that they are the cause of the bubbles. The way the data they focus on is measured does not alert them, and the way they measure their policies’ impacts does not account for the true size of that impact.
The bad news is that this era of inadvertently inflating asset price bubbles by trying to keep consumer prices from falling may be over. Because, this time, we’re not just experiencing an asset price bubble in property and stocks, but rising consumer prices too.
Let’s not focus on China’s role in this today, as important as it may be. Instead, let’s stick with central bankers.
You could say that what we’re experiencing now is a consumer price inflation bubble because the effects of central bank intervention are impacting consumer prices as well this time, not just stocks, bonds, and house prices. In the US especially, inflation is already persistently above 5%, for example.
What makes consumer price inflation interesting is that, unlike asset price bubbles, central bankers are legally bound to react to consumer price inflation. They can ignore the housing bubbles they create, but they can’t ignore their consumer price inflation so easily. It shows up in their statistics, unlike asset price bubbles.
So, you could see house prices go up 5% and the central bankers’ eyebrows will barely twitch. But if consumer prices were to surge that much, there’d be trouble.
Given US inflation is already well above 5%, the trouble has already started too. But what is that trouble?
Well, when asset price bubbles are the side effect of monetary policy, nobody need fear central bankers tightening monetary policy to rein them in. The central bankers don’t worry much about house prices as you can see today.
But, when consumer prices surge, then tighter monetary policy is supposed to follow. And then, suddenly, the bubbles, which central bankers created in property, stocks, and bonds, look vulnerable to being popped.
The same amplifying phenomenon that played out on the way up can play out on the way down. Just as central bankers ignored the vast bubbles they created in property, stocks, and bonds because the Consumer Price Index wasn’t flashing red, when the CPI does flash red, central bankers won’t necessarily consider the impact of tightening policy on the bubbles they’ve created.
Most asset price bubbles end in this way. Inflation in consumer prices eventually rises, requiring tighter monetary policy. But this tightening has a surprise effect on the asset price bubbles, triggering a crash.
The central bankers are surprised by it, anyway. Because they denied the link between their policies and the inflation of the bubbles in the first place, they don’t realise that changing their policies risks bursting the bubbles.
What makes this situation so interesting is that the size of the bubbles in financial markets are so big and so systemically dangerous that it’s possible central bankers will decide to abandon their inflation targets in favour of keeping bubbles going instead.
Especially the bubble in bond markets, where governments finance themselves. Without the government bond bubble, governments could get into financial trouble. Which no central banker wants.
Which do you think is looking more likely? Do you think central bankers will try to rein in inflation at the risk of popping the stock market, property market, and bond market bubble? Or do you think they’ll ignore their inflation mandate in favour of financial stability and keeping their mates at the Treasury funded?
Complete our poll here to tell us what you think.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia
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