Bubble Warning

from the Economist

The False Boom

In 2008, falling markets caused a vicious circle of debt defaults and fire sales by investors, pushing asset prices down even further. The market rebound was necessary to stabilize economies last year, but now there is a danger that bubbles are being created.

[The] more immediate risks may be posed by fiscal policy. Many governments responded to the crisis by, in effect, taking the debt burden off the private sector’s balance-sheets and putting it on their own. This caused a huge gap to open up in government finances. Deficits in America and Britain, for instance, stand at more than 10% of GDP.

The Real Bust

Markets have already tested the ability of the weakest governments to bear the burden of their debt. Dubai had to turn to its wealthy neighbor, Abu Dhabi, for help. In the euro zone, doubts have been raised about the willingness of Greece to push through the required austerity measures. Electorates are likely to chafe at the cost of bringing down government deficits, especially if the main result is to repay foreign creditors. That will lead to currency crises and cross-border disputes like the current spat between Iceland, Britain and the Netherlands over the bill for compensating depositors in Icelandic banks. Such disputes will lead to further outbreaks of market volatility.

Investors tempted to take comfort from the fact that asset prices are still below their peaks would do well to remember that they may yet fall back a very long way. The Japanese stock market still trades at a quarter of the high it reached 20 years ago. The NASDAQ trades at half the level it reached during dot-com mania. Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give.

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