Oscar Wilde, the famous Irish wit, wrote that to lose one parent may be regarded as a misfortune; but to lose both looks like carelessness. One has to wonder what he might have said about today’s major central banks, who have created not one, not two, but at least three sets of important asset price bubbles through their excessively loose monetary policies. By so doing, they have put the world economy at considerable risk when they begin to turn off their monetary policy spigots.
Perhaps the most worrying of these bubbles are those now all too much in evidence in the US equity and housing markets. Courtesy of around $4 ½ trillion in US Treasury and mortgage-backed securities bond buying and the prolonged maintenance of ultra-low interest rates in the wake of the pandemic, US equity valuations have reached nosebleed levels experienced only once before in the past one-hundred years. At the same time, US house prices, even in inflation-adjusted terms, now meaningfully exceed their peak level before the 2006 US housing market bust.
Not to be outdone, the Chinese central bank has created the mother of all credit and housing market bubbles through many years of ultra-easy monetary policy. According to the Bank for International Settlements, over the past decade, Chinese credit to the non-financial private sector expanded by around 100 percent of GDP. That is a faster rate of credit expansion than that which occurred before Japan’s lost economic decade in the 1990s or than that which occurred in the run-up to the 2006 US housing and credit market bust.
The unusually rapid rate of Chinese credit expansion has allowed its property sector to increase to 30 percent of the overall Chinese economy, which is almost double the comparable proportion in the United States. It has also created a large overhang of unoccupied dwellings and has driven Chinese home-price to income ratios in its major cities to levels that make those in London and New York look very low.
The third major sets of bubbles are to be found in government debt markets of the Eurozone’s highly indebted countries. Over the past two years, in response to the pandemic, the European Central Bank (ECB) bought EUR 1.85 trillion in government bonds, including a disproportionate amount of government bonds of the Eurozone’s highly indebted economic periphery. This allowed interest rates on some of these countries’ bonds, like those of the Italian government, to decline to negative levels. It did so notwithstanding the fact that Italy’s public debt level and its budget deficit are now appreciably higher than they were during the 2010 European sovereign debt crisis.
In the year ahead, a major challenge for the world economic outlook will be the great likelihood that the Federal Reserve, the ECB, and the Bank of China, will simultaneously be moving towards more restrictive monetary policies.
With US inflation rising to a forty-year high, the Fed has already indicated that it will end its bond-buying program in March with a view to paving the way for a series of interest rate hikes. Recognizing the long-run dangers of its credit bubble, the Chinese government has already taken measures to restrict credit growth to the property sector. That has caused Evergrande, China’s largest property developer, to default on its loans. Meanwhile in Europe, against the backdrop of rising inflation, the ECB has announced that it will end its Pandemic Emergency Purchase Program in March. That has already caused the difference between Italian and German government bond yields to rise to their pre-pandemic levels.
All of this means that in the year ahead we could see real-world financial market stress as a result of bubbles bursting on several fronts. If ever there was a need for international economic and financial market policy cooperation to guide the world economy towards a soft economic landing, it has to be now.
Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.