December 8, 2014

Is Free money dangerous ?

Free money (and zero interest rates) are the fathers of malinvestment.

Over history, the artificially low cost of credit and central bankers' unsustainable increase in the money supply trigger poorly-allocated business investments.

The dot-com bubble in the late 1990s, the U.S.housing bubble in 2002-07 and the proliferation of those "financial weapons of mass destruction" (derivatives) are past examples of what Austrian economist F.A. Hayek called a byproduct of errant monetary policy, which produced low interest rates and, eventually, misleading relative price signals. causing a boom followed by a painful bust. 

Today, the Federal Reserve and, for that matter, central bankers around the world, have made a mockery of fundamentals as a slowdown in the rate of global economic growth (see overnight data in China, Germany and the U.S. (retail sales)) have coincided with a near parabolic move in the U.S. stock market over the last six weeks. 

Nonetheless, investors' confidence in central bankers' ability to engineer escape velocity and a self-sustaining trajectory of global growth is at a bullish extreme, manifested in relatively high valuations (at over 17x earnings). This comes despite 25% of the world's GDP barely growing (with Brazil, Japan, Italy and Russia in recession) and Germany's and France's flatlining growth and with the U.S. growing at only 2% to 2.5%. 

In light of recent events, we must comment on the price of energy products. The thesis that an oil price collapse of 40% in only a few months is market- and economy-constructive is a weak one and is indicative of the bubble-like optimism of the type that permeates through the U.S. stock market. Do observers really believe that all of a sudden the market has become oversupplied by so much oil?

Free money drives misallocation of capital and overinvestment. This time it washed up in fracking and energy (see below). But energy messes with geopolitics in ways that telecom and housing does not, and this could prove to be much more destabilizing than other bouts of over- investment. It is not like Russia or Iran are going to just go gently into that good night -- they could cause trouble. (Perhaps this even explains why Russia's Putin saw this coming a while ago and why he invaded Ukraine). 

Misleading price signals (manifested in a new all-time high in the S&P Index) are being communicated to market participants. But signs of malinvestment and misallocation of resources have cropped up and represent risk to investors.  

In the mid-2000s the malinvestment of capital nearly took down the world's economic system and stock markets.

Of course, that era was unprecedented in terms of the misallocation of resources.

To the extent that the global growth recovery is sub-par, fragile and vulnerable, the emergence of new and different signs of malinvestment might have a potent and adverse impact on economic growth (especially at the margin) in the years ahead and could be sowing the seeds for the next business downturn sooner than many feel possible.