Why We Have to Talk About a Bubble

The prolonged program of quantitative easing has sent asset prices soaring, even if traditional signs of inflation are muted.

Sticking with his target.

Photographer: Alex Kraus/Bloomberg

Back in November, former Fed chief Janet Yellen described the current low level of inflation as a "mystery." Despite a small pickup in prices, Europe has the same mystery to solve: Economic confidence in the euro area is at its highest point for a decade, according to the European Commission's measure, released this week. But there's no sign of the inflation that you'd normally expect with that kind of economic upsurge. The European Central Bank minutes from December, released Thursday, show some in the ECB are similarly baffled by what they call a "disconnect" between the real economy and prices. 

With QE having multiplied the amount of fiat money issued by central banks in just a few years, it's fair to wonder: How come it didn't trigger much higher levels of inflation than what we now see? The technical answer is that the money created has ended up full circle -- on the books of the central banks.

The more fundamental answer is that QE resulted in a wealth increase for the richest, who consume relatively little of their revenue, while the middle class and the neediest largely failed to reap any benefit. Having not gained from QE, their consumption has not risen, leaving prices pretty much flat.

There are many problems with this, from growing inequality to pressures on social cohesion. But one that has received too little attention up to now is the prospect that we are heading toward a growing asset bubble that will result in a pronounced crash, as Jeremy Grantham, co-founder of the investment firm GMO, argued in a note last week. He predicts a "melt-up" -- where investors pile into assets as prices rise -- followed by a significant decline "of some 50 percent."

What's the connection with QE? The primary aim of QE was, of course, precisely to prevent a financial meltdown in the financial sector as well as in the weakest euro-zone states, which it did. The mechanics of QE meant that central banks printed money so that the financial sector could acquire financial assets, mainly in the form of government debt. The sellers reinvested the newly minted money in increasingly expensive financial assets, hoarded "real asset" alternatives such as real estate, or simply deposited back at the central bank. Higher deposits with the central bank took the place of higher "real-world" lending.

In the U.S., the top 10 percent of households hold over 70 percent of net wealth; the same is true, to a lesser extent, in the rest of the Western world. The wealthiest consume the lowest portion of their income, especially when the gains are exceptional rather than recurring, as with QE. As for the middle class, its income has been capped for decades by cheap foreign imports and an automation wave, none of which were changed by a monetary phenomenon like QE. As a result, only a small fraction of the newly created wealth found its way into consumption, and when it did, it was limited to luxury goods and real estate through higher rent. In 2017 Coutts reported a cost of living well index, a measure of inflation for luxury consumption, went up 6.2 percent, while the corresponding period U.K. consumer price index was up merely 2.9 percent.

Meanwhile, central bankers are still using inflation as a measure to gauge how much more QE they should proceed with. The ECB has repeatedly justified QE expansion because its goal of 2 percent consumer inflation remains unmet. Still, the December minutes indicate some unease there:

Several observations were made on the apparent disconnect between developments in the real economy and price dynamics. This disconnect appeared to have persisted or even increased over recent months, as growth had repeatedly been stronger than expected in the euro area and inflation dynamics had remained largely unchanged or surprised on the downside. This phenomenon was not limited to the euro area, since low inflation had been observed across many advanced economies in spite of strong global growth.

British journalist Ambrose Evans-Pritchard, commenting on the Grantham thesis recently in the Daily Telegraph, put the challenge now in the starkest possible terms, as a threat not simply to the recovery but to democracy:

The central banks themselves entered into a Faustian Pact from the mid-Nineties onwards, falsely thinking it safe to drive real interest rates ever lower with each cycle, until they became ensnared in what the Bank for International Settlements calls a policy “debt trap”. This has gone on so long, and pushed debt ratios so high, that the system is now inherently fragile. The incentive to let bubbles run their course has become ever greater.   

What to do? Central bankers should recognize the mistaken nature of using QE to spur inflation and stop claiming they are tapering QE -- merely code for extending it at a slower pace on the spurious ground consumer inflation is not "strong enough.” Easy money is useful in mitigating a short-term crisis. But far from Schumpeterian wealth creation, where entrepreneurs are rewarded and the benefits trickle down to all of society promoting social mobility, the current system magnifies the status quo and exaggerates existing distortions and inequalities; zombie firms block resources from going to more productive firms, for example.  

Of course, stopping a drug like QE risks the ill effects of a withdrawal. Asset prices may well abruptly correct, with distraught investors and special interests screaming for government help. These calls should be ignored. To alleviate the pain of the transition and the impending necessary corrections, governments must increase investment in the real economy. At the very least, further QE purchases should be directed away from sovereign debt and toward funding infrastructure projects -- for example, through the European Investment Bank, as Blackrock Chief Investment Officer Rick Rieder has advocated.

For that to happen, though, government would have to get more serious about creating the kinds of projects that would attract funding and create transparent vehicles for that purpose. For now, central banks look set to continue their focus on the wrong inflation indicator, potentially steering us straight into the eye of a strengthening storm.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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