How to spot an asset bubble...

Two directors of Mckinsey Global Institute, Charles Roxburgh and Susan Lund opined in an article that appeared in the Financial Times that policymakers and business leaders in should spend time and energy discussing how to prevent the next devastating financial crisis – specifically, how to spot and prick asset bubbles as they are inflating.

For many years, some of the world’s most prominent central bankers said this was impossible. However, new research from the McKinsey Global Institute shows that rising leverage is a good proxy for an asset bubble – and that the right tools could have identified the recent global credit bubble years before the crisis broke. Our new MGI report, Debt and deleveraging: The global credit bubble and its economic consequences, details how debt rose rapidly after 2000 to very high levels in mature economies around the world. But to spot a bubble, we need to know how much debt is too much. Some households, businesses and governments can carry large amounts very easily, while others struggle with lesser amounts.

The answer lies not in the level of debt alone, but in the sustainability of debt. If borrowers cannot service their debt, they will go through a process of debt reduction, or deleveraging. We see today, for example, that many debt-burdened households are deleveraging – voluntarily and involuntarily – by saving more and paying down debt, or by defaulting.

The results show that borrowers in 10 sectors in five mature economies have potentially unsustainable levels of debt, and therefore have a high likelihood of deleveraging. Half of the 10 are the household sectors of Spain, the UK and the US, and to a lesser extent South Korea and Canada – reflecting the boom in mortgage lending during recent housing bubbles. Three are the commercial real estate sectors of Spain, the UK and the US – reflecting loans made during commercial property bubbles. The remaining two are portions of Spain’s corporate and financial sectors, both of which thrived during that country’s real estate bubble, which is now deflating.

These findings confirm that the credit bubble was global in nature and fuelled primarily by borrowing related to real estate. More importantly, we see that this type of analysis could have identified the emerging bubble years ago, when its existence was still being debated.

If these tools had existed and been used in 2006, they would have signalled the growth of credit bubbles. And by pinpointing the sectors and countries, the data would have helped regulators identify the specific sources of the growing problem and address them in a targeted way. For example, they could have required tighter lending standards or bigger margin requirements in specific credit markets that appeared to be overheating.

Chasing the Rising Sun

One stellar feature of the post-crisis global economy is China's remarkable performance. Financial Times reported as follows on China's Q4 2009 performance:

China comfortably beat its target of 8 per cent economic growth last year and came close to overtaking a stagnant Japan as the second-biggest economy in the world, even as signs emerged on Thursday that inflationary pressures are building.

The economy accelerated in the fourth quarter to expand by 10.7 per cent and grew by 8.7 per cent in 2009, in spite of the biggest global economic crisis in generations.

China’s gross domestic product reached $4,900bn, just short of the $5,100bn Japan is expected to register after last year’s contraction, according to Goldman Sachs.

However, consumer price inflation jumped sharply again last month, from 0.6 per cent in November year-on-year to 1.9 per cent, the latest indication that the economy could be at risk of overheating. Factory gate prices rose 1.7 per cent in December, reversing November’s 2.1 per cent fall.

“My first worry is how to control price rises while promoting economic growth, ” said Ma Jiantang, director of the National Bureau of Statistics, in the latest in a series of comments by senior officials about the risks of inflation. “Another concern that is shared by us all is that the price of assets is probably growing too fast. For instance real estate in some cities is growing too fast.”

Andrew Burns, a senior economist at the World Bank, said on Thursday that there were “some signs of bubbles” in the Chinese economy, especially in the housing sector.

Regulators have ordered some banks to stop new loans until the end of the month for fear that frantic lending had been compromising monetary policy that most economists already considered too loose.

Five Chronic Diseases in need of cure...

Martin Wolf, chief economic editor for Financial Times listed in a recent article five major challenges that the world must conquer after The Crisis. Some excerpts from the article are published here:

First, we have the ongoing force of the balance-sheet recession in the US, UK and a number of other significant high-income countries. It is overwhelmingly likely that the highly indebted parts of the private sectors of these countries will seek to lower their indebtedness and raise savings over an extended period.

Second, we have substituted public sector borrowing for private sector borrowing, on an unprecedented scale, for peacetime. This can continue for some time, but not forever, as the US and UK come to look like Italy, but without Italy's healthier private sector finances.

Third, despite modest - and, quite possibly, temporary - reductions, the US, UK, Spain and other erstwhile bubble economies continue to have large structural current account deficits, with substantial offsetting surpluses in China, Germany, Japan, the oil exporters and several other countries.

Yet, so long as these external deficits continue, the countries concerned must be running ongoing financial deficits in either the public sector, or the private sector, or both. In other words, the domestic balance-sheet problem is likely to become not better, but worse, without global rebalancing.

Fourth, the surplus countries - China, most openly - show little or no interest in making the needed policy changes. Instead, they continue to argue as if it were possible for the Earth to run a surplus with Mars. Somehow a way must be found - ideally, co-operatively - to wean the surplus countries from their addiction.

Finally, the financial system remains damaged. Not only does it still own vast quantities of the "toxic assets" its "talented" employees created, but the world is not addressing the structural causes of the crisis. In some ways, the oligopolistic banking system that has emerged from the crisis is riskier than the one that went into it.

The end of an era?

Niall Ferguson, famous Harvard academic, historian and author, recently wrote an article for Financial Times in which he gives an overview of the fundamental changes in political and economic power shifting to the East, notably China. Maybe the end of 500 years of Western Ascendency? Here follows some excerpts from the article:

"Western Ascendancy": that was the grandiose title of the course I taught at Harvard this past term. The subtitle was even more bombastic: "Mainsprings of Global Power". The question I wanted to pose was not especially original, but increasingly it seems to be the most interesting question a historian of the modern era can address. Just why, beginning in around 1500, did the less populous and apparently backward west of the Eurasian landmass come to dominate the rest of the world, including the more populous and more sophisticated societies of eastern Eurasia?

My subsidiary question was this: If we can come up with a good explanation for the West's past ascendancy, can we then offer a prognosis for its future?

Put differently, are we living through the end of the domination of the world by the civilisation that arose in western Europe in the wake of the Renaissance and Reformation - the civilisation that, propelled by the scientific revolution and the Enlightenment, spread across the Atlantic and as far as the Antipodes, finally reaching its apogee in the age of industry and empire?

The very fact that I wanted to pose those questions to my students says something about the past 10 years. I first began to teach in the US because an eminent benefactor of New York University's Stern school of business, Wall Street veteran Henry Kaufman, had asked me why someone interested in the history of money and power did not come to where the money and power actually were. And where else could that be but downtown Manhattan?

As the new millennium dawned, the New York Stock Exchange was self-evidently the nodal point of a vast global economic network that was American in design and largely American in ownership.

The dotcom boom was ending, to be sure, and a nasty little recession ensured that the Democrats lost the White House just as their pledge to pay off the national debt began to seem almost plausible.

But within just eight months of becoming President, George W. Bush was confronted by an event that emphatically underlined the centrality of Manhattan to the western-dominated world. The destruction of the World Trade Center by al-Qaeda terrorists paid New York a hideous compliment: for anyone serious about challenging the American global order, this was target number one.

The subsequent events were exhilarating. The Taliban overthrown in Afghanistan. An "axis of evil" branded ripe for "regime change". Saddam Hussein ousted in Iraq. The Toxic Texan riding high in the polls, on track for re-election. The US economy bouncing back thanks to tax cuts. "Old Europe" - not to mention liberal America - fuming impotently.

If Napoleon had been, in Hegel's phrase, 'the Zeitgeist on horseback", then Arnold Schwarzenegger, the action-hero turned governator of California, was the Zeitgeist behind the wheel of a Hummer. Fascinated, I found myself focusing on empire, in particular the lessons of Britain's empire for America's.

As I reflected on the rise, and probable fall, of America's empire, it became clear to me that there were three fatal deficits at the heart of American power: a manpower deficit (not enough boots on the ground in Iraq), an attention deficit (not enough public enthusiasm for long-term occupations of conquered countries) and above all a financial deficit (not enough savings relative to investment and not enough taxation relative to public expenditure).

Back in 2004 I warned that the US had imperceptibly come to rely on east Asian capital to stabilise its unbalanced current and fiscal accounts. The decline and fall of America's undeclared empire might therefore be due not to terrorists at the gates nor to the rogue regimes that sponsor them, but to a fiscal crisis at home.

The realisation that the yawning US current account deficit was increasingly being financed by Asian central banks, with the Chinese moving into pole position, was, for me at least, the eureka moment of the decade.

The illusion of American hyperpuissance was shattered not once but twice in the past decade. Nemesis came first in the backstreets of Sadr City and the valleys of Helmand, which revealed not only the limits of American military might but also, more importantly, the naivety of neoconservative visions of a democratic wave in the greater Middle East. And it struck a second time with the escalation of the subprime crisis of 2007 into the credit crunch of 2008 and finally the "great recession" of 2009. After the bankruptcy of Lehman Brothers, the sham verities of the "Washington Consensus" and the "Great Moderation" were consigned forever to oblivion.

And what remained? By the end of the decade the western world could only look admiringly at the speed with which the Chinese government had responded to the breathtaking collapse in exports caused by the US credit crunch, a collapse which might have been expected to devastate Asia.

While the developed world teetered on the verge of a second Great Depression, China suffered little more than a minor growth slow-down, thanks to a highly effective government stimulus programme and massive credit expansion.

It would of course be ingenuous to assume that the next decade will not bring problems for China, too. Running a society of 1.3bn people with the kind of authoritarian planned capitalism hitherto associated with the city-state Singapore (population 4.5m) is fraught with difficulties.

But the fact remains that Asia's latest and biggest industrial revolution scarcely paused to draw breath during the 2007-09 financial crisis.

And what a revolution! Compare a tenfold growth of gross domestic product in the space of 26 years with a fourfold increase in the space of 70. The former has been China's achievement between 1978 and 2004; the latter was Britain's between 1830 and 1900. Or consider the fact that US GDP was more than eight times that of China's at the beginning of this decade. Now it is barely four times larger - and if the projections from Jim O'Neill, Goldman Sachs' chief economist, prove to be correct, China will overtake America as soon as 2027: in less than two decades.

What gave the west the edge over the east over the past 500 years? My answer is six "killer apps": the capitalist enterprise, the scientific method, a legal and political system based on private property rights and individual freedom, traditional imperialism, the consumer society and what Weber probably misnamed the "Protestant" ethic of work and capital accumulation as ends in themselves.

Some of those things (numbers one and two) China has clearly replicated. Others it may be in the process of adopting with some "Confucian" modifications (imperialism, consumption and the work ethic). Only number three - the Western way of law and politics - shows little sign of emerging in the one-party state that is the People's Republic.

But does China need dear old democracy to achieve enduring prosperity?

The next decade may well answer that question. Then again, it may take another 500 years to be certain that there really is a viable alternative to western ascendancy.