When the easy money music stops playing

In late 2008, at a meeting with academics at the London School of Economics, Queen Elizabeth II famously asked why no one seemed to have anticipated the world’s worst economic and financial market crisis in the postwar period. She did so at the start of the 2008-2009 Great Recession that was triggered by the bursting of an unprecedented U.S. housing and credit market bubble. That bubble was in plain sight, yet no one seemed to anticipate its bursting. 

Many academic economists and economic policymakers are making the same mistake by being overly sanguine about the likely bursting of today’s global “everything” asset price and credit market bubble. 

This complacency is more difficult to understand considering how very much more pervasive today’s asset price and credit market bubbles are than they were in 2006. This complacency is also more difficult to understand considering the degree to which the Federal Reserve will need to raise interest rates this year to get the U.S. inflation genie back into the bottle. 

Over the past two years, both the Federal Reserve and the European Central Bank have created the mother of all global asset price and credit market bubbles. They have done so by a combined $10 trillion in bond purchases, which have kept interest rates on safe government bonds at ultra-low levels and have forced investors to stretch for yield in ever riskier markets.

Whereas in 2006 the bubbles were largely confined to the U.S. housing and credit markets, today they are to be found in practically every corner of the world asset and credit markets. U.S. housing prices at higher levels than in 2006 even in inflation-adjusted terms, and U.S. equity valuations are at nose-bleed levels experienced only once before in the last 100 years. But major bubbles are also to be found in exotic asset markets such as those of cryptocurrencies and non-fungible tokens.

Worse yet, a massive amount of credit has been loaned at very low interest rates to borrowers with questionable ability to repay. A particularly troubling instance of gross credit misallocation is that characterizing the emerging market economies, which now account for around half of the world economy. Over the past 18 months, these economies have been upended by the pandemic,  and they have become more indebted than ever before. Yet they have continued to have easy access to the international capital market. 

A key and present danger to the U.S. and world economies is that the global asset price and credit market bubbles are premised on the assumption that today’s ultra-low interest rates will last forever. It also must be of concern that once U.S. interest rates start rising, the emerging markets will experience a large reversal in capital flows that could once again expose them to a series of debt crises.

With U.S. consumer price inflation now running at 7 percent and U.S. unemployment now close to its all-time pre-pandemic lows, it’s only a matter of time before the Federal Reserve is forced to substantially hike interest rates from their present zero bound. Underlying this possibility is the Fed’s recognition that inflation is not as transitory as it had earlier assumed, which has prompted it to anticipate three interest rate hikes this year. 

With European inflation now at a record high of some 5 percent, or more than double its target, it’s only a matter of time before the European Central Bank also turns off its monetary policy spigot and begins raising interest rates.

All of this is likely to leave a lot of explaining to do to Queen Elizabeth when the music of easy money stops playing and nobody will have warned her of the asset and credit market crash that will almost surely follow the party’s end. With some justification, she might then ask why the academic community did not learn anything from the bursting of the 2008 U.S. housing and credit bubble.

More to the point, she may ask why they did not warn her in 2022 about the dangers of an even greater and more pervasive asset and credit market bubble than that of about a decade ago.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.