24 November 2003
In the movie ‘The Matrix’ reality is not what it seems. On the surface all is well with the world but to the hero, Neo, something is not quite right. He is offered the choice of a blue pill, which will allow him to continue on with his life blissfully ignorant of the truth, or a red pill, which will enable him to see reality. Inevitably, he chooses the red pill and he is plunged into a horrific mind-wrenching journey. Then he can see that everything he had previously believed to be real was in fact only an illusion.
The current US economy is a little like the illusion of the Matrix. To a casual observer, everything looks normal – actually better than normal. The US economy is beginning to record strong growth, profits are rising and the stock market has been performing well, hitting new recovery highs.
But scratch the surface and some things do not seem quite right. If the economy is really set to grow at 4% (as most believe) why are short-term interest rates only 1% and expected to stay very low? Why are long-term real interest rates still at such historically low levels? If the post-bubble adjustment is over why is the personal savings rate still only 3%? Given that interest rates are only 1% and the current account deficit is a massive 5% of GDP, why has the dollar not fallen much further already?
Many investors, corporate executives and economic commentators seem to have chosen to ignore these questions in favour of welcoming the ‘recovery’. They have ‘taken the blue pill’. If they had collectively ‘taken the red pill’ we would all have been taken, like Neo, on a rather terrifying ride to reality.
For the uncomfortable truth is that the 1990s financial bubble has not burst, at least not fully. The US in particular remains a ‘bubble economy’. The 1990s mania was created by the conjunction of a number of factors. Probably the most important were persistently easy money, structural changes in the world economy that suppressed measured inflation rates, and the combined actions of central banks and governments.
The latter collectively encouraged investment in equities regardless of risk, supported financial markets when they faltered, propped up the dollar, and discouraged purchases of gold. All of these influences, that together acted to create the mania in financial assets, remain largely in place today. Logically this ought not to be the case if the bubble had truly deflated.
The third factor listed above – the ‘moral hazard’ issue – is particularly interesting. The 1990s bubble environment saw the development of attitudes amongst participants in the global financial markets that are now ingrained, but would be alien to a time-travelling investor from the early 1980s.
Notably, it has come to be assumed implicitly that central banks can largely control financial markets if they wish, and that floating exchange rates are, at the very least, highly influenced by government policy. Those central banks that have inflation targets are assumed to be able to hit them with almost decimal point precision. The early 1980s investor would have found such notions hard to swallow. Then, foreign exchange intervention in support of a currency was generally seen as a good reason to sell it, and no-one had much faith in macro-economic management.
The government bond market is a case in point. Bond investors now tend to view long bond yields as representing the outcome of a path of expected central bank interest rates. This perspective leads investors to have the false sense of security that long bond yields can always be controlled by the central bank. In fact, the reverse is closer to the truth. The long yield is determined by the global real interest rate and the long-term expectation for inflation, both of which constrain the central bank’s ability to set short-term rates.
Imagine a crisis during which the dollar free-falls and long bond yields begin to spiral upwards as investors abandon US securities and fear the inflationary implications of currency collapse. If the Fed tried to keep interest rates at 1% in these circumstances then banks would be funded cheaply to buy government bonds, resulting in indirect monetization of the budget deficit and an exploding money supply, which would eventually further harm bonds. In reality the Fed would be forced to raise rates. Higher bond yields would indeed reflect expected Fed interest rates, but market forces would be the driver of these expectations, not the Fed.
A crisis such as this is not as far-fetched as it sounds, being one of the possible ‘end-games’ of the US bubble economy. Up to now the financial bubble has been gradually deflating but liquidity in the economy and in the markets has remained excessive, encouraging renewed ‘mini-bubbles’ in bonds and stocks, as well as a bubble in real estate. At no stage since the year 2000 have either equities or bonds fallen to the sorts of levels that could convincingly mark the final end of the bubble economy.
This is particularly true of US government bonds, on which ten year yields of 4¼% leave room for only about 1¼% annualized inflation after providing for a ‘normal’ annual risk-free real return of about 3%. Notwithstanding deflation talk, 1¼% is not a sensible average expectation for inflation, given that the dollar is still far too high, the US budget deficit is exploding and money growth has been high for a number of years.
The ‘fair’ level for bond yields can only properly be judged after the dollar has fallen much further and the imbalances of the bubble era have been corrected. It is almost certain to be substantially higher than current levels.
The Fed’s extremely aggressive monetary policy has been critical to sustaining this ‘Matrix economy’. The continued overvaluation of financial assets and real estate has allowed the savings rate to remain low as the personal sector has not felt a strong imperative to increase savings when wealth remains comparatively high and interest rates are extremely low. The fact that wealth has remained at high levels relative to incomes has also acted to boost the demand to hold money and thereby helped prevent excess liquidity in the economy translating into a very weak dollar and higher inflation.
Fiscal policy has been important too. Excess liquidity, and the imbalances in the US economy, should already have resulted in a severe fall in the dollar, which would then have undermined the demand for US financial assets, including money, with inflationary consequences.
One of the reasons that this has not happened so far is the huge support for the dollar from Asian central bank buying. But the massive fiscal stimulus that has been applied to the US economy is probably more important. The US fiscal position has deteriorated by 7% of GDP since 2000. Some of this can be ascribed to the cyclical factors, but there has also been an enormous discretionary stimulus.
As was also demonstrated in the dollar bull market of the early 1980s, substantial fiscal stimulus tends to be positive for a currency initially, even though the legacy of budget deficits is eventually negative. Fiscal stimulus increases the demand for funds in the economy and tends to draw in overseas capital. It seems likely that it is the expansion of the US budget deficit that has prevented the dollar declining more sharply.
The degree of fiscal stimulus must surely now be passing its peak, taking away this prop for the dollar, which is consequently looking more precarious. US economic and market bulls must therefore hope that increased international confidence in the US economy and its financial markets will alone be enough to sustain the dollar at overvalued levels. Otherwise, a dollar slide will likely turn into a rout and, as the 1990s bubble then completely unravels, the illusion that is the US ‘Matrix Economy’ will be shattered.