Tuesday, January 15, 2008

Have the Central Banks Fueled Asset Speculation Again?

Remember the emergency year-end credit provided by central banks in Europe and the U.S. last December? The $500 billion in Europe and the $40 billion in America? The borrowing banks did something with that money. They couldn’t make a profit (or just break even) by putting the money in their vaults. They’d have to re-lend it somewhere.

Banks haven’t been exactly rushing to make mortgage loans; we all know that. And consumer spending has been slowing. So it doesn’t look that the banks are throwing loans at consumers. Where did the money go?

Since the new year began, petroleum has reached as high as $100 a barrel and gold has jumped over $900 an ounce. Why these sudden price rises? It’s not like everyone made a New Year’s resolution to drive more or flash more bling. Did the flood of credit at the end of last year fueled more asset speculation?

Something like that happened in 1999-2000. Fear that Y2K computer malfunctions would result in a credit freeze led the major central banks, including the Fed, to pump a boatload of money into the banking system in the fall of 1999. The sky didn’t fall on Jan. 1, 2000. But the stock market jumped. In particular, the dotcom heavy Nasdaq market rose more than 50% between the fall of 1999 and April 2000. Then, stocks cratered.

As the Fed and other central banks now talk about lowering interest rates, we should be mindful of the potential for unintended consequences. With the dotcom and real estate bubbles and busts fresh in our memories, we should realize that, if credit conditions are now eased further, more asset bubbles may result. Are we prepared for that consequence? After all, asset bubbles are what got us into the current mess.

Let's also consider what asset classes might become bubbly. Real estate is spiraling downwards and will for a while. U.S. stocks aren't a good candidate, with losses from the mortgage mess overhanging the stock market and the declining dollar driving capital overseas. Commodities and foreign stocks are more likely to bubble up. That wouldn't help America. The dotcom and real estate bubbles, although ultimately damaging, at least temporarily increased 401(k) balances and home equity. This, in turn, boosted consumer spending, the engine of the U.S. economy. But few Americans benefit from increases in the price of oil or gold. And only wealthy Americans with plenty of capital to send overseas would profit from a bubble in foreign stocks.

So the next bubble would probably hurt, but not help. What game plan do the Fed and other central banks have if things get bubbly again?

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Weiner said...

I believe you are wrong in your analysis. The billions of dollars the American banks borrowed were immediately lent out. Look at the weekly published statistics for bank loans. The loans are up by an amount closely correlated to the loans taken at the fed window. Where did they go? To new car or home loans? I think not. These billions of dollars went right to there investment bank's subsidiaries to shore up their holdings of SIVs,CDOs, and other deteriorating financial instruments. If you were really a nice uncle you would lend me a few billion at an ultra low rate and take my junk paper as collateral. Now that would be a relative to write home about.

Leo Wang said...

The bank loan data is consistent with my analysis, which is that the funds loaned by the central banks were reloaned. The hedge funds and other market players that speculate in petroleum, gold and other commodities rely heavily on bank loans--leverage is crucial to how they boost their returns on capital and I strongly suspect they took advantage of the abundance of credit at year end. The entire $540 billion of central bank loans last December couldn't have just been re-loaned to the borrowing banks' subsidiaries. Banking rules wouldn't allow loans to subsidiaries in amounts that large.