New bubbles in the making?

By Dr Meekal Aziz Ahmed

The global economy is showing signs of life after experiencing the Great Recession. Growth is being spearheaded by strong recoveries in the Asian countries although the industrialized countries are also performing well with the US economy expanding at 3.5 per cent in the third quarter and Japan, Germany and France recording two successive quarters of growth. Yet there are looming risks on the near horizon. The key risk is surging prices of housing and real estate, stock markets, and commodities such as gold. The concern is that this surge in prices is not consistent with, or related to, "economic fundamentals", as economists call it. More specifically, are we seeing portends of new bubbles in asset markets?

The fact is that economists simply do not know. They do know and have strongly recommended a sharp and sustained easing of macroeconomic policies, both fiscal policy and monetary policy. Fiscal deficits are large, injecting fresh demand into the economy. Interest rates, the leading edge of monetary policy, are at unprecedented lows (in the US it is effectively zero). This is as it should be since it is the only way to cushion the recent global economic and financial downburst and prevent the Great Recession from turning into a Great Depression, with its incalculable consequences.

This is the good news. The bad news is that the recovery is being accompanied by surging prices in asset markets noted above reflecting a world awash in liquidity. The compelling question therefore is what is to be done? Should macro policies be tightened to deflate what could be emerging bubbles which have a nasty habit of bursting, as they did recently, and take the global economy down with it resulting in a painful "double-dip" recession?

Unfortunately, the risk here is that such a tightening of macro policy could have the unintended consequence of aborting the global recovery. It could mean a premature withdrawal of fiscal and monetary stimulus just as the momentum of growth was strengthening. Even the dour and conservative IMF is urging countries around the globe to stick with the present easy stance of macro policy until the recovery is more firmly entrenched and assured.

Another problem with the dichotomy between economic fundamentals and asset markets that we see emerging today is that we don't know, and cannot tell, ex ante, whether these are bubbles or simply a cyclical run-up in prices which usually accompany an economic up-swing. Even the great maestro, Alan Greenspan, Chairman of the US Federal Reserve denied that a bubble was emerging in the US. By keeping interest rates too low for too long, he simply made matters worse. The financial meltdown that ensued, in the US and globally, was more severe and costly in terms of output, employment and a loss of wealth than it needed to be.

However that may be, it may surprise many that central bankers don't target bubbles. They may be aware of their existence and keep a weary eye on them. But they don't adjust policies in response. They largely concentrate on other real and financial variables such as output, the degree of slack in the economy, inflation, employment, the money supply and macroeconomic imbalances. This is because they don't know whether there is a bubble to begin with and they don't know how much and how far interest rates need to go up to prick the bubble gently and stem its debilitating consequences in financial markets and the real economy.

Pakistan has experienced its share of bubbles. While growth was rapid in the Musharaf era, it was accompanied by an unsustainable and potentially dangerous run-up in prices in real estate, the stock market, and commodities as economic slack was taken up, resource pressures intensified, and the economy overheated in an ill-advised dash for growth. Even our local Greenspan kept interest rates artificially low although, to be fair, Pakistan had little choice with global interest rates at unprecedentedly low levels as well. This must have created a difficult policy dilemma for the authorities. If interest rates in Pakistan had been pushed up to slow the forward momentum of the economy and keep inflationary pressures at bay, there would have been capital flight as economic agents would have taken their money out of the country in search of better returns abroad. The only option left to policy makers to withdraw stimulus from the economy and slow down the torrid pace of domestic demand growth would have been to tighten fiscal policy. This was something they were obviously reluctant to do.

What did happen is that the economy entered a period of stagflation as inflation took-off amid slowing output growth, and prices in asset markets underwent a large downward correction. But the impact of the bursting of the bubble in Pakistan's case did not, in the main, affect banks and lead to a credit crunch and frozen credit markets, as witnessed elsewhere, but reflected itself in unprecedented turmoil in the foreign exchange market. As confidence waned and the government remained stupefied in the face of a gathering balance payments crisis, there was massive capital flight as everyone encashed their investments in asset markets and took them out of the country. As Pakistan's foreign exchange reserves started to vanish with astonishing speed, we had no choice but to seek recourse to exceptional financing from the IMF.