The next crisis looming: Asset bubbles?

Robert Zoellick, president of the World Bank, recently aired his views on certain dangers arising from the massive monetary and fiscal stimuli governments have embarked upon to avoid the dire consequences of the financial crisis of 2008. Here are some excerpts from the article that was published on FT.com:

As the world begins to recover from the worst downturn since the Great Depression, the conventional wisdom is that we have employed lessons of the past effectively: a flood of money; a dose of fiscal stimulus; and an avoidance of the worst trade protectionism.

Of course, governments knew these dramatic actions would have consequences. Central banks have been watching carefully for early signs of the traditional danger – inflation. Yet in a new era of global competition, companies are unlikely to have the pricing power that led to “demand pull” inflation in decades past; nor are unions likely to be able to make wage demands that contributed to “cost-push” stagflation. Walmart and the developing world’s labour force have changed the paradigm.

Yet the revival of John Maynard Keynes should not lead us to ignore Milton Friedman: where will all that money go? For a hint of the future, look to Asia, where a new risk is emerging: asset bubbles.

Asia is now leading the world economy with increases in industrial production and trade, partly reflecting the growth in China and India. This welcome economic upswing is accompanied by rising equity and property prices.

The combination of loose money, volatile commodity markets and poor harvests – such as occurred recently in India – could make 2010 another dangerous year for food prices in poor countries. Asset bubbles could be the next fragility as the world recovers, threatening again to destroy livelihoods and trap millions more in poverty.

Unfortunately, the chapters in the history books about how to deal with asset bubbles usually precede tales of woe. Asset bubbles can be more insidious than traditional product inflation, because they seem to be a sign of health: higher values lift the real economy, which in turn can send the bubbles higher.

Waiting for bubbles to burst and then cleaning up the aftermath is now a new lesson of what not to do. But tightening interest rates too abruptly – especially where recoveries are weak, such as in the US and Europe – could trigger another downturn.

Australia, with its ties to the Asian economies, has already raised interest rates. Asian countries, which traditionally follow the US Fed’s monetary policy, will be under pressure to follow. But raising rates while the Fed keeps its rates close to zero would cause Asian currencies to appreciate. This would make their exports more expensive and decrease overseas sales, hurting recoveries based on exports. More­over, there is competition from China. The renminbi is tied to a declining US dollar that makes Chinese goods cheaper to buy than those of Asian rivals.

It would also help if North America and Europe took a closer look at the agenda that Australia and many Asian countries are starting to pursue. To build confidence and opportunity for the private sector, the Asia-Pacific countries are advancing structural reforms – including in service sectors – to boost productivity and potential growth. These reforms will help them to compete even if their currencies appreciate.

Perhaps the primary lesson from history is for countries to co-operate in making assessments that distinguish their situations, avoiding one-size-fits-all “exit strategies”, and cautioning against currency or trade protectionism.

These will be the challenges for the Group of 20 nations in 2010. The G20 had better put asset price bubbles and new growth strategies on its agenda. Otherwise, the solutions of 2008-09 could plant the seeds of trouble in 2010 and beyond.