29 July 2011

Why are financial bubbles so easily popped?
When Paul Volcker set out to slay the inflation monster in the early eighties, the Effective Fed Funds Rate had to go up to more than 19% before he was successful. In contrast, financial asset inflation seems to be a delicate creature; it takes only an interest rate of 5%-7% to kill it. Why?

The answer is obviously leverage.

Consider a hedge fund with an equity capital of $5 that borrows $95. It invests the money in the stock market.

At an interest rate of 0%, when the market rises 1% the fund earns a return of 20% on equity. Given five such days in a year when the market rises 1% the fund can easily earn a return of 100% on equity. Nice bonuses all around. Thank you, Mr Bernanke!

When the interest rate is 1% the annual cost of financing is 0.95%. So the market needs to rise nearly 2% to give a return of 20% on equity. If the market remains stationary, the fund undergoes a loss of nearly 20% on equity.

When the interest rate is 2% the annual cost of financing is 1.9%, so the market needs to rise nearly 3% to give a return of 20% on equity. If the market does not rise, the fund suffers a loss of 38% on equity.

When the interest rate is 5% the annual cost of financing is 4.75%, so the market must rise 5.75% to give a return of 20% on equity. If the market does not rise, almost all the fund's equity gets wiped out.

We have not considered staffing and other costs or the fact that a hedge fund can bet on the market's fall as well as its rise. But despite the simplification the idea is clear. Each percentage rise in interest rates increases the risk that a highly leveraged hedge fund can go bankrupt. It is not surprising, therefore, that a Fed Funds Rate of 5% is enough to pop most bubbles.

So what are the implications for policy? The US government has tried to set limits on bonuses, on the transparency of hedge funds and other financial institutions, on capital requirements and so on. I rather agree with Alan Greenspan that no regulator can keep pace with changes in financial engineering. To remove all risk from the system one would need to have a regulator looking over the shoulder of every trader. That would be going the way of the Soviet Union. And I doubt whether even that would prevent catastrophes.

On the other hand, a Fed Funds Rate of about 5% seems guaranteed to prevent any asset bubble from growing, judging from the past decade. But won't that also penalise businesses producing real goods and services? I have argued in Why banks do not lend at near-zero interest rates that both the economics and the evidence give the lie to this fear.

For a firm producing real goods and services, an interest rate of 10% probably won't add more than a percentage point or two to total cost. And this can easily be absorbed or passed on to customers. For financial trading firms, though, such an interest rate would be disastrous.

There is a curious corollary to the above thesis. I argued that raising the interest rate to moderate levels prevents any money from going to feed bubbles. Carrying the argument a step further, low interest rates, by diverting money to asset inflation, keeps the inflation of real goods and services down.

This conclusion militates against all common sense. In its favour, consider the fact that before the Great Depression, the crash in Japan, and the Great Recession, inflation was very low. That is to say, low inflation need not be a sign of slow monetary expansion, but quite the opposite: an indication that money is growing steeply.

Category: Economics

Philip George
Understanding Keynes to go beyond him

Buy my new ebook
Contact Me
October 2022
September 2022
March 2022
January 2022
October 2021
August 2021
July 2021
August 2019
October 2018
April 2018
December 2016
October 2016
August 2016
July 2016
April 2016
March 2016
January 2016
December 2015
November 2015
October 2015
September 2015
August 2015
June 2015
May 2015
February 2015
November 2014
October 2014
August 2014
May 2014
April 2014
December 2013
October 2013
July 2013
May 2013
January 2013
November 2012
October 2012
August 2012
July 2012
June 2012
May 2012
March 2012
February 2012
January 2012
December 2011
November 2011
August 2011
July 2011
June 2011
May 2011
April 2011
March 2011
August 2010
October 2009
May 2009
June 2008
March 2008
February 2008
January 2008
December 2007
August 2007
June 2007
May 2007