By Andy Xie
The global financial system has experienced one bubble after another because major central banks have kept monetary policy loose. Prolonged loose monetary policy has made the financial system extraordinary large relative to the real economy. This change forces central banks to respond to negative shocks, like the bursting of a bubble, from the financial system. Such responses make the financial system even bigger. This vicious cycle explains why speculation has become such a powerful force.
A bubble cannot expand forever, even in an environment of loose monetary policy. The balance between fear and greed can tip over when the price of an asset becomes too high, like Internet stocks now relative to the average. The subsequent deflating bubble, in a continuing environment of loose money, just shifts air into other assets.
The talk of monetary tightening in the United States or China will not be followed up with strong enough actions. Real interest rates will remain negative until another crisis, like high inflation or hyperinflation or political crisis, force the hand.
Gold is the safe asset in today's environment. As paper currencies lose credibility, the demand for gold will surge. The alternative digital currencies are fool's good, really scams to take advantage of people's fear over the potential collapse of paper currencies.
One More Bubble Peaks
Internet stocks have been skyrocketing in a subdued economic environment. The propaganda is that such companies have fast growth despite sluggish economies. The problem is that any growth story is limited by how big the economy is.
Internet businesses usually redistribute revenues from existing businesses. Advertising supports most Net companies. The total advertising dollar amount is a stable share in an economy. Even if Internet companies take the whole pie, their revenues cannot exceed that limit. But, in the early days of increasing market shares, they can register 50 percent to 100 percent annual growth. If one extrapolates over a few years, they are worth huge amounts. That story is fiction if one looks at the ultimate constraint.
For example, Facebook trades at 100 times earnings and US$ 150 billion in market capitalization. No company grows forever. When it stagnates, its stock can trade at 10 times earnings. Hence, Facebook needs to increase its profit 10 times to justify its current stock price. How many media companies make US$ 15 billion in advertising today? Zero.
E-commerce is another focus of speculation. Its business model is taking the market shares away from the traditional distribution channels. Again, the profit for distribution is limited by the size of the market and competition. One cannot extrapolate the growth rate of a business in its early days.
Crime and Little Punishment
Financial markets are supposed to allocate capital efficiently. Financial institutions are rewarded for doing this job. If the real economy achieves capital income of 20 percent of GDP, financial institutions could charge 20 percent of that or 4 percent of GDP in value added. And 40 percent of that or 1.6 percent of GDP could be profit for them. Valued at 10 to 15 times earnings, financial institutions should be worth 16 to 24 percent of GDP.
Bubble formation has been a feature of finance throughout history. The above analysis counters the driving force in finance – making more and more money. Bubble formation reflects the contradiction between this desire and reality. In theory, a bubble is a market mistake and should occur infrequently.
Two changes in the past 15 years have made bubble formation a constant feature of financial markets around the world. The inefficiencies in capital allocation and income redistribution to finance are the main reason for today's sluggish global economy.
At the macro level, globalization has made inflation slow to emerge, as multinational companies can shift production around the world in response to cost pressure. This force has given central banks more room in increasing money supply without facing the inflation consequences for years. Hence, central banks around the world have become more active in response to economic fluctuations. The consequence is a rising ratio of money supply or credit to GDP. By definition, this means a bigger and bigger financial system, which needs more and more income to survive.
The real economy, as the previous analysis indicates, can only bear so much. Bubble formation has become central to supporting a bloated financial system. A large and bubbly financial system is unstable. Its periodic collapse brings down the economy, which triggers more monetary stimulus. Hence, constant monetary stimulus and an ever-expanding and bubbly financial system have formed a vicious cycle.
At the micro level, more and more financial institutions and products have risen to game the system. When the financial system is so large, gaming the system is the only way to achieve consistent and high profitability. This is why financial scandals occur so frequently nowadays. The recurrent financial scandals continue because their perpetrators are punished lightly.
Financial crimes and misdemeanors, especially in capital markets, seem to lack victims that would ramp up emotion against such deeds. Flash trading, for example, is the latest scandal. It involves some entity that comes in between buyers and sellers in the capital markets and tries to be faster than either to arbitrage the bid-offer differences. This strategy involves making a little from each trade and doing it billions of times. While the total amount involved is large, no individual seems to have lost much. The victim is the public. However, no single individual will spend money and effort to stop it. Hence, such a practice can last a long time. The current uproar may stop flash trading. However, something else will emerge to replace it.
Perception, Not Substance
Flash trading is small in the overall scheme of money printing and bubble making. The United States' non-financial sector credit is 2.6 times GDP, and China's is 2.0 in the official system and an additional o.3 to 0.4 in the gray market. When the interest rate is artificially kept low by one percentage point, all in the name of stabilizing financial markets or stimulating the economy, 24 percent of GDP in income, more than all the income for capital in a normal economy, is transferred from savers to someone else. This is the juice for financial crimes and misdemeanors.
The sustained and large redistribution of income from the real economy to a speculative financial economy is literally bleeding the global economy dry. The catchphrase today in the same circle of financial policymakers who brought us the financial crisis of 2008 is that "low inflation" is bad for the global economy. It is essentially an argument for looser monetary policy after five years of a very loose one.
I have argued (1) that inflation is not low, just check out non-tradables like housing, health care, education and agro products, (2) that falling prices of IT products, which brings down the CPI on average, are not meaningful for inflation measurement, and (3) that multinational companies keep inflation low in the short term and cannot in the long term.
What's important in today's financial world is perception, not substance. If you check out what important financial figures have proposed in the past, they have been good for forming bubbles, not for growing the real economy. The reality is that they are wearing the same pants as the bubble-makers. That decides what they say.
The perception that policymakers do the bidding of financial speculators has become more real with each round of stimulus. As the speculative community gains more and more wealth, it has the financial power to influence or even control policymakers. The dynamic of weak economy and continuous stimulus becomes self-reinforcing.
A Strange Sight
A bubble cannot expand forever even if monetary policy remains loose. The balance between greed and fear tips over when the relative valuation is too high. Commodities, emerging market stocks, currencies and properties, and now Internet stocks have peaked. There are two things unusual about how a bubble deflates today.
First, they deflate slowly. Take iron ore. It halved in 2012 from the peak, bounced up 50 percent in 2013, and is down one-third this year. Currencies, bonds, and properties in emerging economies seem also to follow the pattern of slow and protracted deflation.
The multiyear deflation of a liquid asset is not often seen in history. Usually, a bubble builds up slowly and then pops. Among the usual patters were Hong Kong's property market in 1998, IT stocks in 2000 and the U.S. property sector in 2008, among others.
Second, when a bubble deflates, a new one tends to arise somewhere else. After the property-cum-credit burst in 2008, stocks in general and Internet stocks in particular rose spectacularly afterwards. The following commodity prices are followed by surging property prices in London and New York. It seems that, as soon the air comes out of one bubble, it finds another to inflate right away.
As analyzed previously, the increasing influence of the speculative community, the repetitive stimulus policy and the consequent weak economy reward more speculation. Hence, when a speculative crowd disperses in one market, they regroup in another.
The Internet stocks are likely to behave in a similar pattern. Some stocks have tumbled by 20 percent. They are still in bubbly territory. Still, they will bounce back some. There will be another round of tumbling, perhaps in the second half. A rebound will follow again. In 2000, Internet stocks collapsed quickly. The changed environment is why they fall slowly in this round.
No Yellow River, No Quitting
Three factors will end pervasive speculation: surging inflation, speculators quitting en masse or political backlash. Inflation is something that I have talked about. Despite the caveats to the low inflation story (e.g., surging prices of non tradables not in the CPI basket and the pulling effect of the falling prices of IT product) it has come slower than expected.
How quickly multinationals can shift production in response to rising costs must be a major reason. It decreases labor's bargaining power to protect real wages. Workers are competing against people even though they do not know where they are. Hence, a wage-price spiral is hard to take on in a city or economy. It needs to be a global phenomenon. That would take a long time to occur.
Speculators quitting en masse, a usual cause for bubble popping, is a factor that is becoming less likely nowadays. So many money managers are speculating with other people's money. They gain fat management fees for sticking around and a huge share in profit when asset prices rise. The second part does not usually require cashing out. Just mark-to-market value would do. This is why small Internet stocks enjoy such lofty valuations. Their supporters line their pockets for every year that they can keep them up. This incentive structure is the reason that the speculative crowd will not disperse voluntarily.
Political backlash is becoming more real over time. Flash trading has been around for years. The book that Michael Lewis published on the subject brought it to public attention. The ensuing uproar is likely to force the U.S. government to restrict it. Of course, the people who make a living from it will move to something else that may do more damage. The masses may eventually realize that their falling living standards are a consequence of what's happening in finance. It could lead to sweeping political changes like in the 1930s.
Only changing the policymakers will change the global economy. While national leaders change, the bunch who manage major economies have remained in the same circle for the past two decades. People do not ask why, after causing so much damage, they are still around. The power of money from the speculative community is distorting the narrative in the media.
The Yellow River is reached when people realize that they are being brainwashed to accept a worsening living standard.