TCS Daily

Mind the Banks

By Christopher Lingle - February 15, 2005 12:00 AM

While many people were still reeling from the injuries inflicted by the bubble, absurdly-inflated prices richocheted around the world. For example, the governments in China and Korea have been complaining about real estate bubbles as evident in soaring prices in parts of Shanghai and Seoul. Undertaking appropriate counter-measures requires that an appropriate diagnosis be made since public policy remedies are as ineffective as when doctors guess wrong about the conditions of their patients.

To understand the problem, consider some of the common interpretations of the sort of asset-price frenzies like tulipomania or property bubbles. Although economic theory provides no explanation of psychological urges, there are a few good economic explanations for the existence of speculative bubbles. Unfortunately, many economists and analysts peddle misinterpretations while overlooking the sensible ones.

According to Lord Keynes, asset bubbles arise from "animal spirits" released by capitalism. Although this is perhaps the worst assessment, it is also the most widely accepted. A similar thesis with wide acceptance speaks as though there can be a "madness of crowds".

It is not surprising that these interpretations offer so much appeal, especially to non-economists that are contemptuous of people who have become rich through speculation. These portrayals are of investors as gullible or stupid people that require guidance from the government. (Meanwhile, the same governments can exploit those lucky enough to be successful by squeezing them for tax revenues to support redistributive political programs.)

However, careful reflection indicates that there is a serious disconnect from reality in the above explanations of bubbles and speculative frenzies. Let's start with the condition of stability that characterizes most markets, most of the time.

Each day there are trillions of transactions that take place within millions of markets for different goods and services conducted by billions of people. And this has been occurring with increasing scope over hundreds of years.

Markets tend to be stable because of the qualitative nature of individual players. Some will be better informed and some will be less well informed. There will be optimists about the direction of prices ("bulls"), and there will be pessimists about prices ("bears"). It these conditions were absent, markets would continuously spin out of control and would collapse frequently.

While there have only been some truly dramatic instances of bubbles, it is truly remarkable that there have been so few. The fact that there are so few brings into question the psychological explanations offered by Keynes and others.

It turns out that the real cause of bubbles is excessive credit expansion by central banks. China's money supply growth is being dictated by a foreign exchange policy that fixes the yuan against the US dollar.

As it is, the People's Bank of China supplies an equivalent amount of yuan for every dollar from exports and foreign investment that enters China (almost $154 billion in 2004, up 33 percent year-on-year). Consequently, the growth rate of the money supply (M2) rose was 19.6 percent at the end of 2003 with the target for 2004 set at 17 percent. This has pushed interest rates down for consumers and speculators.

Similar problems emerge in other Asian countries that pursue export-led growth strategies. While attracting ever-larger inflows of foreign currencies, the domestic aim of monetary policy is to keep interest rates low in the vain hope of stimulating production.

Without such extensive expansion in long-term credit, there could be no financial support for the "irrational" urge to continue throwing money at speculative ventures. Unless there was monetary expansion to finance new bank credit, the transactions in the rest of economy would have to fall by an offsetting amount.

Consider the bubble. New technologies generated promises of large potential returns and were met by exaggerated optimism. But hysteria alone was not responsible for pushing valuations beyond any connection to economic reality.

Speculative manias, like in property, operate similarly in that price increases of an asset attract more investors seeking quick capital gains from the expectation of even higher prices. Inevitably, the speculative frenzy runs out of steam when asset prices reach levels that are obviously unsustainable. At that point, a round of profit taking sparks panic and flight out of the asset so that prices collapse.

The good news is that a collapse in real asset prices after a bubble bursts on its own cannot induce a recession. This is because declining prices are a symptom and not a cause of economic downturns. Indeed, falling prices of the over-inflated assets are the painful but necessary process of readjustments to restore stability in affected markets.

At the same time, financially-imprudent central bankers cause substantial economic pain in other parts of the economy. Expanding credit and making interest rates artificially low will divert resources and production towards badly-conceived investments made temporarily viable by cheap credit. Eventually, these misguided investments will become unsustainable and lead to idle capital, excess capacity and rising unemployment. In turn, banks become illiquid and then insolvent as firms cannot service their debts as their cash flows dries up so that the number of defaults and non-performing loans rises.

There is a simple rule that the governments in Beijing and Seoul must remember if they want to stabilize their domestic real estate markets. And it is that both booms in the overall economy and speculative bubbles are symptoms of the irresponsible inflation of credit resulting from monetary policies executed by central banks. Of course, these impulses are also supported by interventions in foreign exchange markets to keep their currencies from appreciating.

Christopher Lingle is Global Strategist for


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