A Funny Thing Happened on the Way to the Stock Market Record

Investors get edgy when asset prices are down, but they should be more concerned at times like now, when prices have gone up, up, and up. Through Dec. 17 the S&P 500 index has gained 27% this year. The market feels as frothy as the top of a nutmeg cappuccino.

“We enter the next decade with interest rates at 5,000-year lows, the largest asset bubble in history, a planet that is heating up, and a deflationary profile of debt, disruption, and demographics,” Michael Hartnett, chief equity strategist for BofA Global Research, wrote in a recent note.

There’s a bigger issue here than whether stock and bond prices are too high. The more serious question is whether the economies of the U.S. and other wealthy nations can no longer grow without producing destabilizing bubbles—spikes in asset prices unjustified by fundamentals. Or, worse yet, whether the bubbles themselves are crucial to generating economic growth.

The circumstantial evidence for a dysfunctional relationship between economies and bubbles is troubling. The last time the U.S. jobless rate got down to almost as low as it is now was the late 1990s and 2000. That boom was fueled by a mania of investment in telecom infrastructure and dot-com startups that ended abruptly at the turn of the century, when gluts formed and prices got too high. The bubble popped. Growth was rescued by a surge of overinvestment in housing, which was pumped up by stupid or fraudulent subprime mortgage lending. The popping of that bubble led to the worst economic downturn since the Great Depression.

Now the funny-money cycle seems to be happening all over again. Interest rates in Japan and Western Europe have broken below what used to be called—naively, we now realize—the “zero lower bound.” Economic historians say this appears to be the first time in the history of the world in which negative interest rates are widespread. Scholars of ancient Mesopotamia are invited to say otherwise.

When rates on safe securities go negative—or ultralow, as they are in the U.S.—investors feel compelled to take on greater risk to get what they consider an acceptable return on their money. They “reach for yield.” Default-prone Argentina found buyers in 2017 for a 100-year government bond. Greece’s 10-year bonds have found takers at yields of just over 1% a year. In the U.S., investors are snapping up risky “covenant-lite” corporate loans that have been stripped of the protections for lenders that ordinarily discipline the borrowers.

“I am very worried,” says Mayra Rodríguez Valladares, managing principal of MRV Associates, a New York-based consulting and training firm for the financial sector. Banks’ assertions that they have plenty of capital and liquidity to withstand the next downturn aren’t reliable, because “you can’t control fear,” she says. “When fear takes over, it’s hard to stop.”

Bubbles are not all bad. Sometimes it takes the prospect of enormous riches to get people to make investments that end up being good for society, even if the investors lose their shirts. That applies to canals and railways in the 19th century, fiber-optic networks in the 1990s, and companies in hot areas such as drones, batteries, solar power, and virtual reality today.

But bubbles also generate waste. The housing bust left hundreds of unsightly and unsafe “zombie subdivisions” across the American West, the Lincoln Institute of Land Policy wrote in a 2014 report, Arrested Developments. The poor and working class suffer the most from boom-and-bust cycles, because they’re the last hired and first fired and are more likely to invest at the worst time, right before things go bad. It’s ironic that at a time of low inflation, there’s been rioting in Chile, Colombia, Ecuador, Iran, Hong Kong, Lebanon, and Sudan over, among other issues, the high cost of living. A bubble in real estate is one of the incitements to protest in Hong Kong, which has the world’s most expensive housing.

So it’s natural to ask why this keeps happening and what, if anything, can be done to take the bubbles out of economic growth. Former Federal Reserve Chairman Ben Bernanke partly explained it in 2005 when he identified a global savings glut: foreign investors, including the Chinese, were pouring money into the U.S. because their savings far exceeded good investment opportunities at home. Some of those foreign savings, alas, were wasted on those arrested housing developments. Lawrence Summers, a former U.S. Treasury secretary and Harvard president, has built on Bernanke’s theory with the notion of secular stagnation: a chronic, worldwide lack of spending because of the aging of society and the rise of companies such as Apple, Airbnb, and Google that don’t need much physical capital. Summers argues that the economic expansion would ebb if left alone and is being sustained by governments using artificial means: deficit spending and low interest rates.

Minsky, the economist who said stability breeds instability, may have had the most complete diagnosis, even though he died in 1996, before serial bubbles became a thing. Building on the work of others, including the Briton John Maynard Keynes and Michal Kalecki of Poland, Minsky focused on the financial side of the economy—flows of money, not just goods and services.

“Profits,” Minsky wrote in 1992, are “the key determinant of system behavior.” He said financing tends to degenerate from safe (“hedge”), to risky (“speculative”), to outright irresponsible (“Ponzi”). The Minsky moment—not his term—is the collapse of prices when people abruptly realize that financing has become reckless and unsustainable.

There’s a troubling new analysis of where we are today, in the Minsky tradition, called Bubble or Nothing. The 64-page report was issued in September by David Levy, chairman of the Jerome Levy Forecasting Center LLC in Mount Kisco, N.Y. Levy is a former associate of Minsky and the third generation of forecasters in his family. A hedge fund he launched in 2004 to bet on falling short-term interest rates gained 500% for investors before closing in March 2009, shortly after rates bottomed.

When investors reach for yield, as they are now, it’s because they “see no other way to obtain financial returns that are anywhere near their goals,” Levy wrote in Bubble or Nothing. Pension fund managers, for example, feel they have to take risks to fulfill promises to retirees. In 1992 public pension plans assumed they would earn a return of 8%, about what they could get on 30-year Treasury bonds. Reasonable. In 2012 they were still assuming they could earn almost 8% a year, according to a study by Pew Charitable Trusts, even though the yield on safe 30-year Treasuries had fallen to 3%. Unreasonable.

The core problem, Levy says, is that household and business balance sheets have gotten too big—top-heavy, you might say. He focuses not only on debt, on the right side of the balance sheet, but also on assets, which appear on the left. While having lots of debt is obviously precarious, he says, having too much in assets is also problematic for the economy as a whole. It can indicate overinvestment (too many houses in the Phoenix exurbs) or excessively high valuation of whatever assets exist (so prices are unsustainable).

Americans emerged from World War II with little debt because consumption was rationed during the war years. They owned few assets because private investment had been suppressed and valuation of assets was pessimistically low, with a price-earnings ratio in 1949 of less than 6 for the S&P 500 (it’s 21 now). But balance sheets grew. In each successive business cycle, the ratio of debt to income grew as lenders competed for market share. By the 1980s it began to be a problem. Ominously, a growing share of the debt went to buy existing assets rather than new ones: It was inflation vs. creation.

With balance sheets getting too big to fail, the Fed came to the rescue in each recession with interest-rate cuts to reduce the carrying cost of all that debt and to prop up the of rate-sensitive stocks, bonds, and other assets. It worked like a ratchet. Rates fell in each successive cycle because the bigger balance sheets grew, the lower interest rates needed to be, Levy says.

True, households in the U.S. have paid down some of their debt since the 2007-09 financial crisis. But the nonfinancial corporate sector has gotten even deeper into hock. “Corporate America’s fragile debt pile has emerged as a key vulnerability,” Oxford Economics Ltd. senior economist Lydia Boussour wrote on Oct. 31. Half of investment-grade corporate bonds are in the lowest tier by credit rating, vs. 37% in 2011. And 80% of leveraged loans are covenant-lite, vs. 30% during the financial crisis, she wrote.

Unfortunately for the would-be rescuers—or enablers—at the world’s central banks, interest rates are about as low as they can possibly get in Western Europe and Japan. (The Fed still has a little room.) The banking system begins to break down at negative rates because depositors, who supply banks with funds, refuse to lose money by leaving it in the banks. At some point they’re better off keeping it under the mattress. “We are very aware of the side effects” of negative rates, European Central Bank President Christine Lagarde said after her first board meeting on Dec. 12.

Lagarde has a bigger problem than does Fed Chair Jerome Powell. She’s up against ratios of private nonfinancial-sector debt to gross domestic product above that of the U.S. The ratios in Australia, Canada, China, and South Korea are, in fact, higher than the ratio was in the U.S. at its 2009 peak, according to the Bank for International Settlements. That’s why Levy predicts the next crisis will begin abroad. “It may not be as bad for the United States as in 2008-2009; it is likely to be worse for most of the rest of the world,” he wrote.

The fix seems simple enough: De-risk balance sheets by allowing the air to come out of asset prices and paying off debts. “The best is to grow out of it gradually and consistently, and it’s the solution to many but not all episodes of current indebtedness,” says Mohamed El-Erian, chief economic adviser to the German insurer Allianz SE and a Bloomberg Opinion columnist.

But as Keynes taught, what works for a single household doesn’t work for the economy as a whole. One person’s savings deprives someone else of income. The business profits that Minsky pegged as the key determinant of system behavior depend on constantly increasing investment in houses, factories, software, etc. And those investments are largely financed with debt.

The only way businesses could make a profit at a time of deleveraging would be if governments took up the slack with massive public spending, as they did in World War II. But even that wouldn’t work if it bolstered the private sector’s confidence and led households and businesses to releverage. The war was a special case. In the U.S., wrote Levy, “that situation included grave household and business fears, great uncertainty, government quotas, outright bans on some kinds of spending, a powerful social force for the population to comply with the government’s programs, massive government deficit spending equal to a quarter of GDP, and hyperdrive economic growth.”

Levy concluded that the inevitable correction to balance sheets, whenever it comes, will produce “serious financial turbulence, systemic credit problems, and generally unsatisfying economic conditions.” He wrote that “by far the trickiest priority” for the government is to rescue the economy without inducing new risk-taking by the private sector, which would generate the problem all over again. A “benign transition,” he wrote, is “next to impossible.”

Given the ugly alternatives, governments are keeping the game going through stimulative fiscal and monetary policy. But for how long? The late economist Rudiger Dornbusch once said, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” —With Enda Curran

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