Monday, 9 September 2013

Bubbles, dangerous beauty!

Everyone is captivated by them, children and adults alike!

They are used also to describe and be analogous to, complex features of our lives. Bubble formation or nucleation is used to describe the formation of our universe and the period of expansion in the short time after the Big Bang. For most of us, I guess it is comforting to think that we live in a bubble universe......but bubbles burst!

Much as I love the debate on astro-physics and quantum theory, I'm really more than happy to leave that to the experts! Instead I want to focus this blog on another use of bubble theory, that which deals with economic models relating to inflation and the formation of bubbles that can harm our economies.

With the globalisation of trade and the advent of World wide corporations, so the management of trade and individual economies has become larger and more complex.Governments are competing in a race to the bottom in attempts to keep the value of their currencies down, to keep export prices competitive. Normalisation of interest rates could unleash strong inflationary pressure.

Currently the most dangerous bubbles forming, and lurking almost unseen by the vast majority of us,  are asset bubbles. These bubbles form when there is over inflation of an asset price (demand pull), as an investment vehicle. The bubble is thus formed by rapid price rises over a short period, but this is not supported by demand (over a longer period) or by an underlying inherent lower value.

Inflation of the bubble (see this as an aggravation of the situation) serves to make it less stable. In the aftermath of the recent global recession and in major asset classes there have been some serious contributory factors to bubble inflation, that have been deployed to stimulate economic growth.

These have been prolonged low interest rates and over inflation of the money supply (quantitative easing). Because of these actions there are potentially inflated bubbles in Carbon (oil and fossil fuel industry), property, Gold (rare metals generally), agricultural land and property. The scale of the bubble may vary in priority from country to country, but in effect they are all linked due to the globalisation of the banking system. Most of these economic instruments, as politicians like to call them have been deployed in all of the major economies, I might wonder how capable they are at playing these instruments as opposed to their voters?!!

Let's take property as a case study, partly because we have already seen a fairly major collapse of just such a bubble in the US, which has led to many of the current problems! A derivative is a loan or financial product that is secured against an asset, in this case a mortgage, which provides the underlying security. Because of a housing shortage in the US (not exclusive to US,  UK and Japan are vulnerable too), leading to a spike in property prices. Hedge fund managers saw this as an opportunity with minimal risk and created a huge demand. This had to be underpinned by the creation of more mortgages, which in turn led to riskier lending and created a demand for more housing (over inflation of the price, underlying loss of asset value and increased risk). As house builders caught up with demand, so house prices began to level off and even fall. This created negative equity and exposed the risk of the over inflated asset price. The sub-prime lending (as it came to be known) had started and had too much momentum to be restrained, the bubble collapsed.

Unfortunately these tell tale signs can be seen in other assets/commodities, it might even be reasonable to expect that hedge funds would look for an alternative support mechanism for the derivatives market (although you might hope with the benefit of property hindsight!). There is great concern that oil, coal and gas investment has formed a bubble whereby the value is over inflated in relation to the amount that can be extracted and used, if we are to meet emission targets for Carbon Dioxide. Given that this bubble is large in comparison to the property bubble and that fossil investments underpin so many pension funds, it is difficult to see how the current economic system could recover were (or should that be when!), the bubble to collapse.

Other bubbles are also worth consideration: agricultural land values and food commodities have seen huge increases in investment over the last few years. Although the US first saw these increases at such a scale, in the last couple of years, there has been a global land grab going on. Such investments are now threatened by climate change induced (or exacerbated) water scarcity, crop pests and disease. Forecasts have put potential losses on investment as high as 5 trillion pounds (£5trn).

Thinking of things at a more human level, some recent research has suggested the formation of a productivity bubble! Companies have looked solely at the bottom line, with employees seen merely as another asset to be sweated! The hours worked have got longer and the holidays taken have been less as workers have been made redundant, or not replaced, leaving the rest to pick up the additional workload.

Productivity increased globally, however this is now starting to flatten off as chronic stress and illness in the workplace manifest themselves. In fact it is likely that productivity could start to fall again, if global temperatures continue to rise and more virulent disease affect the population. It is not sustainable to continue to inflate executive pay and the asset register on the grounds of infinite improvements in productivity!

The only real way to avoid several catastrophic collapses, is to live within our means and not to print money against future productivity that can't be met because it makes a false assumption of infinite resources and continuous improvements in productivity.


I have added the link below to an article in the International Debt Observatory, looking into the potential problems surrounding unconventional fossil fuels. It was recently published (post my blog), but serves to underline the problems emerging.