From one bubble to another?

Why are bags bouncing back so fast after such heavy crashes? What is causing the increase in volatility? Could financial markets conceal previous bubbles that the pandemic has blown up? In this article we answer these questions through Austrian business cycle theory.

In mid-2018, we published on this portal a critical reflection on the European recovery after the Great Recession, analyzing the possibility that the continued commitment to expansionary monetary policies could be forming bubbles that could be the germ of new crises in the future.

Two years later, stocks around the world have experienced an unusual year, beginning with historic declines and closing the year with a rapid recovery. In this article we will try to analyze both phenomena in Europe, all from the Austrian theory of the business cycle.

Let’s see!

Creating a bubble to get out of another

“Starting from the premise that the basis of the problem was widespread mistrust in financial markets, the logical conclusion was that the solution should be to restore confidence, guaranteeing the solvency of market agents.”

As we all know, in Europe and the United States the favorite instrument of the economic authorities to face the Great Recession has been monetary policy. Starting from the premise that the basis of the problem was widespread mistrust in financial markets, the logical conclusion was that the solution should be to restore confidence, guaranteeing the solvency of market agents.

This could only be achieved with massive injections of liquidity into the system, for which measures were taken such as reducing interest rates and reserve requirements, bond purchase programs, and increasing financing facilities for financial entities; to the extreme of rescuing those in trouble.

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For this reason, as of 2013, clear signs of recovery began to be seen in the main economies of the world, which was interpreted as a success of monetary policies given the evident failure of the experiments based on fiscal stimuli. Therefore, the reaction was to further increase the expansionary sign of these policies, especially through quantitative easing (QE) plans.

Since then, programs of massive purchases of financial securities by central banks, in environments of almost zero real interest rates (and sometimes even negative), have been a constant in the world economy, although these have gradually been seen moderate as employment and gross domestic product (GDP) recovered. However, the outbreak of the coronavirus has convinced the European Central Bank (ECB) of the need to reinforce these policies, for this, with the creation of a new asset purchase plan of up to 1.85 trillion euros.

Bad investments, less profit

“Cheap money” policies can distort financial markets, leading to bad investment cycles.

However, and despite apparently positive results, from the Austrian theory of the economic cycle, two criticisms could be made of the stimulus policies that have been applied. First, the artificial increase in the money supply has been able to distort the perception of market agents about the real profitability of their investment opportunities, which means that resources could have been allocated to unprofitable projects. Something similar could have happened in the public sector, which has been given disincentives to adjust due to the fact that the fall in debt issuance costs has made it possible to maintain the deficit levels in many countries with relative ease.

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Second, a wrong analysis of reality could have confused the monetary authorities about the real scope of their own policies. As we all know, the objective of central banks in Europe and the United States is price stability, which is usually quantified in inflation targets close to 2% per year. The problem is that general price indices are not always a reliable indicator of inflation, since they are only discretionary weighted averages that do not capture the evolution of all economic sectors or changes in the relative price structure.

An artificial expansion of credit, therefore, could boost investment and thus increase the demand for producer goods, pushing up their prices, but this rise could be seen somewhat blurred in the general inflation indices, if this increases. it was also offset by a drop in the price of consumer goods.

Likewise, we could also find certain distortions in the financial markets, undoubtedly those greatly affected by the monetary expansion policies. With interest rates close to 0 and bond markets where it was increasingly difficult to find profitable opportunities, many investors have migrated to the equity markets, having to accept levels of volatility higher than those they might have been willing to assume in a first moment. The result is that public intervention in fixed income markets could have ended up generating artificially high demand in equity markets, distorting the risk-return ratio that agents would have established spontaneously on their own.

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We can visualize this problem in the upper graph. Most of the stock valuation methods have as an essential component the ability of a company to generate profits that, later, can be passed on to shareholders in the form of dividends, which would allow us to assume a directly proportional relationship between earnings and value in bag. However, the evolution of variable income securities issued by non-financial companies in the European Union since the launch of the QE does not seem to respond to that logical relationship that would establish the spontaneous order of the market, since the growth of the value of the shares far outweigh the evolution of operating profits. Margins show an even worse trend, with levels lower than those of 2014.

The data therefore show that non-financial companies in the European Union have not experienced on average a proportional growth in their profits (neither in total volume nor in margins) in relation to their listing on the stock market. Quite the contrary, the negative evolution of corporate earnings could be seen as an indication of that cycle of bad investments that we discussed earlier.

The explanation for the growth in the value of equity liabilities on companies’ balance sheets should not, therefore, be due to an increase in profits. Alternative hypotheses could be sought, such as that in the valuation made by the markets, financial results weigh more than operating ones, but the reality is that the lower cost of financing costs in recent years has significantly reduced the differential between both variables.

It could also be argued that investors have been more optimistic. That is, despite not seeing attractive benefits in the present, they hope to have them in the future. But this explanation is unlikely in an environment of generalized economic slowdown, such as that experienced between 2018-2019.

The shortcomings of the general price indices as a measure of inflation have been able to hide the overvaluation of certain financial assets and the breakdown of the balance between profitability and risk they present.

Therefore, the reason that would best explain the growing weight of equities as a financing instrument for companies is the constant increase in the price of shares, which, in turn, would have created incentives for entrepreneurs to expand their issues due to the forecast that the demand for these securities will continue to grow.

But why was the demand for stocks growing? The answer to this is quite simple. And it is simply because, as we have commented previously, there could have been a “displacement effect” of the demand from the fixed income markets to the variable income markets.

In practice, this migration of investors would have taken place through a reduction of the “substitution effect” that normally exists in both markets. Or put another way, many agents could have ended up demanding equity assets, simply because the market did not offer them many other options.

Underestimating inflation

Now let’s look at the effects of these policies from a monetary point of view.

As we can see in the graph below, the economic recession of the 2008-2011 period led to a slowdown in the growth of monetary aggregates, but the positive trend has resumed with more force since 2015 as a consequence of the QE. This continuous creation of money has made it possible to multiply the monetary base, but let us bear in mind that it has done so at rates much higher than the average growth of the economy: 1.95% per year for the GDP of the euro area in the face of average annual increases of 8.74 % (M1), 5.03% (M2) and 4.76% (M3).

Monetary Mass Euro1

The situation of the eurozone economy is, therefore, that of a growing money supply and a speed of money circulation that has not managed to fall enough to compensate for it, with a general price level below 2% and interest rates. considerably modest growth. Following the model of the quantity theory of money, the logical thing would have been to think that inflation and GDP were not picking up because not enough money was being injected into the system, when in reality monetary expansion was distorting financial markets and generating an overvaluation of certain assets.

The reason, as we have already explained, is that, at times, the general price level is an imperfect indicator of real inflation, since it does not include the price of financial products or changes in the relative prices of consumer goods. and production.

In this way, the European monetary authorities could have underestimated the effect that their own policies were having on the markets and this would have pushed them to continue injecting money into the system without considering, perhaps, the real risk of creating new bubbles. This could have led to certain stocks trading above what investors would have valued by analyzing the real evolution of the companies that back them, which would help to explain the overreaction of the stock markets with sharp falls in the face of the first doubts generated by the impact of the coronavirus.

The problem with assuming this hypothesis is that if we look at the current situation, none of the fundamental factors have changed. Corporate profits remain low (they have fallen due to COVID-19), the general level of prices is bordering on deflation, and “cheap money” policies are more in force than ever. All of this should, perhaps, make us more skeptical of the rapid recovery of the markets in recent months, given the possibility that in some assets it is simply the formation of a new bubble to overcome the previous one.

The current crisis could therefore admit two readings. We can understand it as an opportunity to liquidate the unprofitable investments of the economy, and, incidentally, to end the bubbles before they grow too large, or, on the contrary, as a situation where the only possible way out is to create even more money for give financial relief to the State, families and companies. Assuming, by the way, the risk of continuing to fuel bubbles that might one day burst, at least from the perspective of Austrian business cycle theory.

In short, the expansionary policies of the ECB seem to favor the authorities for the second option, although in the long term the threat of a depreciation of the euro in an environment of public deficit and increased debt could moderate this preference. In either case, the problem of monetary issuance is once again at the center of the European economic debate, in a new chapter of a controversy that has accompanied the Old Continent since the adoption of the euro.

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