So how can central banks spot asset bubbles and go about puncturing them early? First I will give you a more disciplined answer and then I will give you answer which is easier for people to understand.
If you have a situation where the amount of credit in the economy is expanding much more rapidly than the economy itself, or if you have a situation where asset prices are expanding more rapidly than the economy, more rapidly than the wage growth, and if that continues for a long time, then you have got a very good symptomatic problem.
If house prices are rising faster relative to people’s wages and that persists, then you have a very good chance that it turns into a bubble, because in the end, houses have to be bought by people with their wages. You can’t happen to be using a line for a very long time. Now that’s a more technical answer.
The second way, which is perhaps more useful is if you get to a situation where large sections of your society are able to earn a very large amount of money while sitting on their backsides through asset price inflation, then chances are that asset price inflation is a bubble because its non-productive to the economy. If you are able to sit in your house, do no work and get richer year by year, just because the house is going up in value, that’s not economically sustainable.
One point that you make regularly throughout your book is that the obsession of central banks with inflation targeting is one of the reasons they tend to ignore asset bubbles building up. Could you throw some light on that?
The problem comes from central banks defining inflation in too narrow a way. They define inflation as only the change in prices of goods and services, the sort of things we buy in shops — clothes and electrical goods — things like that. And the services we pay for. Those things go into the basket of what is considered to be inflation. But lots of other things that we buy, like houses and stocks, none of that goes into the inflation basket.
Yet, in practical terms, it’s very important for our expenditure. They ignore such items
because it again comes back to the political problem. If asset prices are built into the inflation numbers, then they would be obliged to take action when the inflation rate goes up, when it becomes too great, which means they will be obliged to sometimes stop the economic expansion, which becomes politically difficult. In a way, it’s a way of ensuring that they don’t have to do the hard tasks.
Which is the next big bubble waiting to burst? Why? Or would you say there are lots of them?
At the moment, as I said, I don’t think we have too many huge bubbles. Where could the next one be inflating? Potentially in China. I think that will turn into a bubble. Probably emerging markets is the next big bubble. Other than that, I would say in the developed markets in western economies, there effectively is a bubble in debt. And that is unlikely to burst in a conventional manner, because the governments can print money to get out of debt.
You seem to suggest western nations should use the printing press to pay off the outstanding debt. Why do you say that?
What I am saying is that we have now become so indebted in the West, that were we to try to pay off the debt in the conventional manner, the degree of economic contraction would be so severe that we would find ourselves in a situation like the 1930s, the Great Depression. The alternative is that we go into something like that 1970s, when we technically monetised the debt away to create inflation. Both of those scenarios are very bad. But the 1970s scenario is less bad than the 1930s.
What concerns me, however, is that if we are going through that option, it is very important that we recognise the mistakes that led up to it. We must reform the system so we do not make the same mistakes again. And that’s basically why I wrote the book. My concern is that we are going into the endgame of monetising the debt without ever admitting to ourselves that’s how we got into the problem in the first place. So we will repeat the mistake again.
Wouldn’t it lead to a highly inflationary scenario, given the amount of debt that needs to be paid off?
It will almost certainly lead to high inflation and that would be very damaging. If it led to hyperinflation like in Zimbabwe’s level, that would be devastating. We can achieve this without going into hyperinflation, but we cannot achieve this without going into high inflation. So it then becomes a question of judging which is better —to go through a deflationary slump, like the 1930s, or inflation rate of say 10%, like in the 1970s. The latter would, in my opinion, be the lesser of two evils. There is no doubt it’s a bad solution. We don’t have good solutions.
“As a rule, we favour capitalism in an expansion and socialism in a contraction,” you say in your book. What do you mean by that?
When economies are expanding, when profits are growing, we are creating more jobs, we are very happy to let the market run its course and have no interference in that process. That is effectively capitalism. But once the cycle turns negative and we get the whiff of a slowdown, then we start to ask our governments to do things like the cash for clunkers programme, step in and start the consumption, underwrite jobs, and print money: basically, own the risk of a capitalistic system on the government’s balance sheet. And that’s the socialism part of it.
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