Thursday, December 29, 2005

Reflexive bubbles

Paul McCulley of PIMCO discusses the feedback mechanism at work in the housing bubble (and seems to call the top). I recommend the whole article (whimsical as it is), which also touches on Bretton Woods II, Asian and OPEC mercantilism, etc. He also makes an interesting observation that bond markets now assume that the Fed has tamed and will continue to tame inflation, and long term rates reflect projections of the real interest rates necessary to do so.

If Fed-engineered changes in nominal rates no longer reflect changes in long-term inflationary expectations, but rather changes in real rates, then logic suggests that long-dated income-producing assets – bonds, stocks and real estate – will become inherently more prone to bubble and burst.

Accordingly, it seems to me, asset prices inevitably must take on a higher priority in the Fed’s reaction function than during the War Against Inflation. As long as inflation was too high for the Fed’s secular taste, bubbles and their bursting didn’t carry grave harm. They misallocated resources, to be sure, like all good Austrians properly preach.

...when home price appreciation is running higher than mortgage rates, the market booms, if not bubbles, as momentum players chase the market higher, a text book example of what George Soros calls reflexive demand. But once the momentum breaks – and again, Morgan, declining affordability is the fundamental break – reflexive demand becomes reflexive supply, as former speculative buyers become eager sellers.

Reflexive markets – and property is one if there ever was one – inherently tend to have V-shaped tops, not rolling tops. Thus, both volumes in total home sales, particularly existing home sales, and MEW are set to fall sharply in the year head. Not the stuff of recession, I hasten to add, Morgan, but clearly the stuff of a serious slowdown in consumer spending.

MLF: Won’t that be a problem for foreign members of the BW II arrangement? Didn’t you say that they are as addicted to our spending as we are to their financing of our spending?

PM: Yes, Morgan, I did say that. Which implies that when the American property market comes off the boil, maybe turning tepid, the world will feel the impact, not just American homeowners. Such is the nature of globalization, when the ex-USA world has a shortage of aggregate demand or, put differently, runs a surplus of savings relative to desired domestic investment.

1 comment:

STS said...

I found McCulley's confidence that the Fed has inflation whipped (like Ford's '76 "WIN" campaign buttons) a bit odd. I guess he's talking about "core" inflation rather than the energy component, say.

It seems to me that the global economy is poised between a massively deflationary labor surplus and a massively inflationary credit boom. I'm guessing this is a sort of saddle-point equilibrium and should we get nudged away from it, there could be either dramatic inflation or deflation.

The credit boom seems a lot more likely to end abruptly than the global labor surplus, so my guess is a deflationary movement. And we're already a long way down the path of inflating the money supply (low policy rates, regulatory inattention to exotic lending practices, explosive growth in dubiously managed credit derivates, etc.) But Helicopter Ben promises more money creation as needed, the Bank of England is giving up on tightening and Trichet had to browbeat the ECB into a qtr point hike (so not much appetite for tighter rates in Europe either).

So we just keep expanding credit and adding jobs in China, India, etc. Can we get all the way to "full" employment of existing labor skills in emerging countries before something bad happens?

If we could, then as the global labor surplus diminishes, domestic wages would start rising, triggering renewed Fed tightening and the asset bubbles could be gradually deflated.
(Ditto for Euroland/ECB).

But the timescales don't seem to fit. Surely the 2x devaluation of the dollar has to happen somewhere *before* full employment in emerging markets. I don't know. But maybe dollar devaluation could happen "aong the way" without creating a
global recession?

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