WARNING SIGNS

Dan O’Brien on the dangers in the financial system,

ARECENT conversation with a Wall Streeter who is worried about bad things happening in financial markets got me thinking about bubbles and, more particularly, how to measure them. By coincidence the conversation took place almost a decade to the day since the first rumblings of the financial meltdown took place.

Not seeing the risks associated with the build-up in imbalances across the western financial system in the middle of the last decade was a huge failing of the economics profession. What’s worrying is that the same mistake looks as if it is being made again.

One reason for that is that nobody really understands fully and thoroughly how the financial system works, and how its many parts all interact with each other. It is a human construct that has become more complex than any one person, or even a group of people collectively, can understand. When we don’t understand something we can’t predict when it will go wrong and in what way.

The Great Recession, which was caused by the financial sector, was the defining event of the 21st century so far. Among other things, it has left governments saddled with dangerously high levels of debt which would make a similar crisis, if it were to occur, harder to respond to.

Another problem is measurement. Unlike consumer price inflation, governments do not compile comprehensive data on asset price inflation. While we have incredibly detailed information on what is happening to hundreds of goods and services prices, and these are aggregated to give an overall inflation index, there is nothing comparable for asset prices.

If there was a well-constructed inflation index covering shares, bonds, commercial property and other assets, red flags would go up sooner and be better understood if price rises rose sharply or jumped to historically unusual levels.

Central bankers and other policymakers remain hyper alert to even small shifts in consumer price inflation — something that was a real problem in the 1970s and ’80s — but either ignore asset price inflation or actually generate it, via quantitative easing.

That said, there are a range of individual indicators from different asset classes which show what is happening to prices. In many cases those indicators are flashing red for anyone who cares to see it.

Government bonds have long looked to be in bubble territory (I don’t know of a source for long run price changes of government bonds, but if any readers know of one please do get in touch). The most commonly cited measure of bonds is not their price but what they yield, which is derived from the price.

Yields for many sovereigns, including Ireland’s, are at or near historic lows. That reflects an abnormally high demand for the stuff. While large-scale purchases of government bonds by central banks have contributed a great deal to very high sovereign bond prices (the European Central Bank now owns around a third of the outstanding stock of Irish government bonds), very low yields in Europe pre-date the start of Frankfurt’s QE programme.

It simply does not make sense that investors are currently prepared to accept a return of less than 1pc on Irish 10-year government bonds when they sought returns at least five times higher before the crisis. That is particularly the case as default risk is considerably higher now given much higher levels of debt.

But it is not only the sovereign bond market that it a cause of concern. The conversation that triggered this column centred on European corporate bonds. A recent blog post by Zero Hedge highlighted the quite insane fact that, as of 10 days ago, junk rated corporate paper in Europe was yielding less than — wait for it — US government debt of similar maturities.

The precipitous rise in European corporate bond prices correlates very closely with the decision of the ECB to start buying company debt as part of its QE programme. I don’t wish to criticise the ECB — policymakers are flying blind in the post-crisis world — but there is at the very least something (let’s put it politely) a little asymmetrical in Frankfurt’s obsession with keeping consumer price inflation down while actively pushing up asset prices to levels that are not reflective of credit risk in any way.

European share prices give somewhat less cause for concern. The Euro Stock 50 and Irish indices remain below pre-crisis peak, but in the UK and the US equities have surged to all-time highs in recent weeks and months. Given political and policy issues in both countries, investors do not appear to be pricing in the very considerable risks both economies face.

If the money that is pouring into many asset classes was doing what it was supposed to do — increase productive investment in economies — that would be one thing. But, as discussed below, it is not.

And not only is the financial system not doing what it exists to do, but it increasingly looks as if it is putting the real economy at risk again by inflating bubbles, the benefits of which go mostly to a narrow group of market participants (and that is before taking into account the market-rigging rackets that remain extensive in the financial world). It increasingly seems as if too few lessons were learnt from the crisis.

The purpose of the financial system to is to channel money from those who have it to those who can put it to good use. Channelling credit to businesses is the most important economic function of the system — a large share of corporate investment spending is financed by monies borrowed from banks or obtained from investors via the bond and equity market.

The seizing up of the western financial system a decade ago had a profound effect on investment spending across the developed world. In the OECD as a whole, if fell by a tenth in 2009, the worst year of the crisis. In many countries, including Ireland, the decline was much bigger.

The recovery in investment spending, 85pc of which is accounted for by non-government agents in developed countries, has also been extremely weak by historical standards. In many economies it remains below the levels of a decade ago.

Among the five big economies in Europe, only Germany has seen investment rise by any meaningful amount over the past 10 years, as the chart shows, and the 10pc increase recorded over the decade was very poor by historical standards. As of the first quarter of this year, investment in France and Britain was only just returning to pre-crisis levels.

Spain, which suffered a similar kind of crisis to Ireland, with a particularly severe collapse in the construction component of investment, is still a quarter below the levels of a decade ago.

But it is Italy where matters are worst. Investment is back at levels recorded 20 years ago and, with an ongoing banking crisis, increases over the past couple of years have been feeble.

An economy that doesn’t invest is one that can’t grow.