The False Allure of Bubble Economics
Ten years after the last financial crisis, the effects of the bust have largely been forgotten. And why not? Things could hardly be better.
The stock market is booming. Unemployment is approaching levels not seen since the early 2000s, and before that not since the 1960s. Even discouraged workers are coming back into the labor force.
The near-dead real estate market is approaching all-time highs of the 2006 subprime bubble as new developments spring up like mushrooms in hot markets like Manhattan and Seattle.
And while prices subject to government intervention (banking, college tuition, child care, health care, and housing) have soared, new technology and innovation have pushed down private sector prices for cars, furniture, clothing, cellphone services, TVs, and travel. The other most consumed items, like YouTube, Facebook, and popular mobile video games, remain free of charge.
Thanks again to technology, the United States is approaching energy independence because of the shale gas revolution, and thanks to that oil prices have been subdued for more than three years now.
Congress just pushed through the biggest tax reform since the 2001 Bush tax cuts. The only thing not exactly like the 1999 tech bubble is the federal government, which is a far cry from achieving the second budget surplus since the 1970s. The monthly chart of the Nasdaq until the end of January, as well as stock valuations, look exactly like in the early weeks of 2000, the last of the famous equity bubbles.
Initial Coin Offerings and cryptocurrencies have replaced the IPOs of the 1990s but the promise of the next technological revolution is the same.
The sentiment is exuberant, and almost everyone is positive on the near-term outlook for stocks and the economy. Everybody seems to be winning now, whether making money in a highly or poorly paid job, seeing their retirement savings increase in the 401(k) stock market account, or making multiples in paper profits trading cryptocurrencies.
Nobody wants the party to stop, like it did in 1999 and 1929.
It Won’t Last
But there is another thing eerily similar to the bubbles of the recent and more distant past, which most people like to ignore: The Fed has initiated a tightening cycle for over two years now.
After basically telling the market the Fed had its back during the 1998 Long-Term Capital Management crisis, the Fed hiked rates almost 2 percent from Jan 1999 to June 2000 because even it realized the tech bubble and margin speculation had to be contained.
As usual, this did not end with the soft landing the central planners always hope for and never achieve, but with a crash of epic proportions that took the Nasdaq down 80 percent in less than two years. Investors had to wait 15 years for it to see the old high of 5,132.
History also credits the Fed with popping the 1929 bubble by starting to tighten in 1928, taking the Dow down 85 percent, with a 25-year wait to see a new high in 1954.
And although the Fed’s recent rate hiking cycle from 0 percent to 1.25 percent is minuscule in historic context, it is at least something relative to the zero interest rate period of the last ten years, as well as the age of quantitative easing.
Why does this matter? Because the market, whether it’s real estate or stocks, is built on the shaky foundations of ever-expanding debt.
Both companies themselves and individual stock speculators have been gobbling up shares on margin, pushing both NYSE margin debt as well as corporate debt to all-time highs in absolute terms. The same goes for bank loans for real estate, and of course federal government debt.
While companies issued record amounts of shares in 1999 to buy up the shares of competitors, and issued record amounts of debt to take companies private in 2007–2008, companies have now issued record amounts of debt to buy back their own shares.
While venture capitalists wasted hundreds of billions in unprofitable dot-com projects in 1999, the new generation of venture investors is wasting tens of billions in unprofitable Initial Coin Offerings or companies that don’t make any money, like Uber.
Even European soccer players are surpassing the valuations of the last transfer craze of the early 2000s. This time, Paris Saint-Germain had to pay $250 million for Neymar Jr. where Real Madrid “only” paid $80 million to get one Zinedine Zidane in 2001, one of the best players in history.
Today some clubs pay that amount to sign run-of-the-mill central defenders.
The Debt Problem
Debt, in and of itself, is not an issue when it is used for productive purposes. However, the Fed has distorted the market by keeping interest rates too low for too long, thus making unprofitable ventures “profitable.”
Because banks can manufacture credit out of thin air and loan it out at a profit, and expect the government to bail them out if something goes wrong, loans are issued with imprudence—just like subprime mortgages of a decade ago.
Once the spigot of cheap credit is turned off, unprofitable projects will have to be liquidated, just like in the subprime crisis.
As usual, this will affect the most marginal and unprofitable ventures first, like the most useless of the crypto Initial Coin Offerings and subprime auto loans. But then, the credit crunch will work itself to the center of the system, and even profitable companies and ventures will suffer.
Amazon’s stock declined 95 percent in the dot-com crash; Goldman Sachs was down 81 percent during the 2008 financial crisis. Then and now, the best companies and sectors will survive and will find their way back.
However, when the inevitable bust comes, and all the paper fortunes built on cheap credit are wiped-out, people will curse the bubble as much as the bust.