I’m Forever Blowing Bubbles

Leiden, a.d. VIII Id. Sep. MMDCCLXVIII A.U.C.,

This post might be a bit… dry, because it is about monetary policy. However, I think it contains some important information on what is going on in Europe right now. So if you promise to read this, I will first treat you with a funny English song, and in the end I will give you the solution to Europe’s current economic problems…

It seems like this song covers the behaviour of central banks pretty well at the moment. While economic growth has been slow in Europe, in some countries the stock markets have exploded in the last few years. Not regarding the recent decreases as a result of the plunges on the Chinese stock markets, the Dutch stock market is almost at the same level as before the financial crisis of 2008 (AEX Index), the same is true for the French stock market (CAC40) and the main German stock exchange is even much higher than it was before the crisis (DAX). It can be said that the prices on the stock markets do not reflect the underlying economy, companies do not make giant profits, so holding stocks should not be particularly attractive. Yet, people are very willing to pay a lot of money for stocks on which they will not receive high dividends, nor should they expect the price of stocks to go up based on increases in underlying value of those companies, due to retained earnings. So it seems like there is something going wrong, something which has already been argued about the American stock markets (Forbes).

I think it has everything to do with the Quantitative Easing (QE) program of the European Central Bank (ECB). QE (Definition of QE) is a process in which a central bank creates cash, buys bonds (Definition of bonds) from banks with that cash, and thus increases the money supply in the economy. It do so hoping that banks will lend this money to investors or consumers, who can then spend this money, which should lead to increased economic growth. Currently the ECB is doing exactly this, it even announced it would expand its QE program (Source). It does so, because European economic performance has been rather lackluster, in spite of low energy prices, QE programs and the low value of the Euro compared to other currencies (The Economist). Moreover, the inflation rate is very low, by using QE the ECB hopes to increase the inflation rate. Deflation is generally seen as negative for economic growth, and by preventing it, QE should thus be a two-edged sword.

However, QE does not seem to really work to get the European economy going. So even if banks wanted to invest, there are not that many companies to invest into. So what do they do with all this money? They go to the stock market, buy stocks, and hope to earn some money as long as the stock market keeps gaining value. In other words, they are creating new bubbles on the stock markets, which should be the last thing we want, seeing we are still recovering from the previous financial/housing bubble. In other words, inflation for a lot of goods and services is very low, because of low demand in the wider economy, however, the inflation rate, so the price increase, of stocks has been remarkably high, creating what certainly looks like a bubble. Therefore investors are dreading the moment the ECB will stop using QE, as this will probably be the needle that makes the bubble burst.

This is exactly what is going on in the United States of America as well, where the Federal Reserve (the Central Bank of the USA) is expected to raise the interest rates, probably in March. The Bank of International Settlements has now even warned that emerging market economies might take a hit when the Fed raises the interest rate. Many such countries have used the low interest rate in the USA to borrow money there, but when the interest rate will be raised, debtors will face higher interest rates as well. This could be harmful to those economies, as they already face quite some challenges at the moment.

Meanwhile back in Europe, the ECB seems to have decided that creating financial bubbles to stave off deflation is a trade off that is worth while. Moreover, in the ECB’s defense, it is not very clear what other solutions to Europe’s troubles are, if QE does not work. I do not think that more government spending in general is going to help an awful lot, especially not in the Southern European countries, seeing how high their public debt already is. Larger government deficits would simply create other problems in most European countries. In the case of France more economic reforms might do the trick. In the case of the Netherlands and Germany increasing domestic consumption by letting the wages increase might help, which would then lead to higher demand for Southern European products as well (Five years old, still relevantRecent IMF Report). Lastly, Germany could increase public spending on its ageing infrastructure (IMF on German Infrastructure). Nevertheless, QE is a dangerous card to deal, especially because both in the USA and Europe investors are investing using borrowed money. If the bubble bursts, a lot of people will have lost a lot of their own and of other people’s money, which makes the ensuing chaos especially large.

QE, thus, has failed at kick starting the economy, but it is still being used to prevent deflation. Seeing both the low interest rate and QE fail to get Europe’s economy growing, in spite of low energy prices and depreciated Euro, the ECB has exhausted its resources. It does seem to have decided that bubbles on the stock markets are a trade off worth making, probably betting that slowly increasing the interest rate and tuning down QE will prevent these bubbles from bursting, and will rather allow them to slowly release ‘air.’ Whether the ECB really is able to do so, remains doubtful, maybe it is even akin to hubris. Yet, most economists agree that deflation is disastrous for economic growth, so the ECB cannot really be blamed for doing what most experts say it should do. However, the ECB is indeed forever blowing bubbles.

Bottom Line: It really seems like the ECB is forever blowing bubbles, the question is whether the stock market bubble is more dangerous to the wider economy than deflation. Also, as promised, I would give you the solution to Europe’s problems:

One thought on “I’m Forever Blowing Bubbles

Add yours

  1. Yep. Cheap money is inflating asset bubbles (not price inflation) as people seek returns higher than cash as well as trying to dump QE cash into something…


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