As a big fan of the history of the financial markets I was excited to see Edward Chancellor as the first speaker on the last day of this year’s Risk Management Conference. His talk was titled The Consequences of Extraordinary Monetary Policy: An Historical Perspective on the Current Environment. When Paul Stephens introduced Chancellor he said he felt it would be useful to have a financial historian speak at RMC. I agreed when he said that and believe it even more after listening to the talk.
When discussing monetary policy he notes that low rates result in a search for yield. As an example cites the Tulip Bulb Mania as actually being a function of a search for yield. The point is that speculative bubbles never occur in periods of tight interest rates. When interest rates are low there is a lot of liquidity and money flows to speculative investments. Stated another way credit booms tend to feed on themselves and when credit stops flowing the result can be a catastrophe. He also showed a graphic that depicted different types of bubbles and noted that they tend to cluster and this clustering tends to happen around periods of easy monetary policy.
Central bankers do not make the association between easy credit and bubbles. Their view of bubbles is that they cannot be recognized ahead of time. He gives several examples of markets that appear very expensive or nonsensical in the current market environment and potentially developing bubbles.
An interesting chart in this presentation was the percent of high yield as a share of US Corporate Bond issuance is near an all-time high. This is usually a precursor to the deterioration of credit. He also noted that the median house price divided by median family income has retraced about half to the peak in 2006. He noted when comparing new home prices to median income we are actually at a higher level than 2006. He finished up by showing that US household net worth is at record levels when considered a percent of GDP (higher than 2006). He considers this paper wealth and it should deflate at some point in the future.
Current credit conditions have been supporting emerging markets, but this appears to have already turned lower. He specifically noted that China has experienced a huge boom in credit. He notes the collateral on credit in China is suspect as well. He noted that China is not the only emerging market experiencing a credit boom as emerging market credit issuance as a percent of world GDP is at record levels.
He finished up noting that low interest rates distort capitalist systems. He turned his attention to Japan and discusses deflation. He states that deflation is not the end of the world and noted that Apple lowers prices on products systematically but that doesn’t keep us from buying Apple products. With respect to Japan he points out that low interest rates created a system where weak companies could continue to survive. These companies may not have survived in an environment of higher rates. He finished this final section noting that low interest rates beget low interest rates. He turned to the US and stated that record profits don’t seem to make sense to him at this time.