Ten Years After Lehman (2): Bubbles Galore & Zombies

by Edward Chancellor*

In 1776, the English man of letters Horace Walpole observed a “rage of building everywhere”. At the time, the yield on English government bonds, known as Consols, had fallen sharply and mortgages could be had at 3.5 percent. In the “Wealth of Nations”, published that year, Adam Smith observed that the recent decline in interest had pushed up land prices: “When interest was at ten percent, land was commonly sold for ten or twelve years’ purchase. As the interest rate sunk to six, five and four percent, the purchase of land rose to twenty, five-and-twenty, and thirty years’ purchase.” [i.e. the yield on land fell from 10 percent to 3.3 percent].

Smith explains why: “the ordinary price of land … depends everywhere upon the ordinary market rate of interest.” That’s because the interest rate discounts and places a capital value on future income. All the great speculative bubbles in the past – from the tulip mania of the 1630s through to the global credit bonanza of the last decade, have occurred at times when interest rates were abnormally low.

The trouble is that after the Lehman Brothers collapse, central bankers refused to accept this fact. The position of Ben Bernanke’s Federal Reserve was that the real-estate bubble was caused by lax regulation rather than his predecessor Alan Greenspan’s easy money. If this were true, then taking short-term rates down to their lowest level in history – to zero in the United States and negative in Europe and Japan – was sensible. But if Smith was correct, then monetary policy in the wake of Lehman’s bust was a case of the hair of the dog.

In the last decade the world has witnessed bubbles galore: in industrial commodities and rare earths; in U.S. farmland and Chinese garlic bulbs; in fine or not-so-fine art, depending on your taste; in vintage cars and fancy handbags; in “super-city” properties from London to Hong Kong, and across China’s tier-one cities; in long-dated government bonds; in listed and unlisted technology stocks; and in the broader American stock market.

Fed officials notoriously failed to spot the real-estate bubble until after it burst. That’s because the current generation of monetary policymakers was schooled in the belief that bubbles didn’t exist. The experience of the subprime crisis apparently left them not much wiser. In April 2016, Fed Chair Janet Yellen, flanked by former Fed chiefs Paul Volcker, Greenspan and Bernanke, denied that the United States was a “bubble economy”. A bubble market, said Yellen, was one that is “clearly overvalued” and marked by strong credit growth.

Yet at the time U.S. stocks were very expensive compared to historic levels. They are currently more overpriced on dependable valuation measures, such as total market value to GDP and on a replacement cost basis (Tobin’s Q) than at any time save for the 2000 dot-com bubble. By the end of the first quarter, U.S. non-financial stocks were 85 percent overvalued on a replacement cost basis, according to economist Andrew Smithers. American corporations have also been borrowing like there is no tomorrow.

A second technology bubble is evident in the nosebleed valuations of tech firms such as Tesla. In August, the market value of Elon Musk’s firm overtook BMW’s even though the profitable Bavarian luxury carmaker produced 30 times as many cars last year as the loss-making Tesla, whose shares have since declined. Seven of the world’s 10 most valuable companies are tech stocks, headed by the trillion-dollar Apple. Away from public markets, profitless unicorns, such as the taxi-hailing firm Uber, sport multibillion-dollar valuations. With so much dumb money about, one of Silicon Valley’s new mantras is “spray and pray”.

Consider what history will surely record as one of the most absurd speculative manias of all time: the cryptocurrency bubble. Bitcoin is pure digital fairy dust. Last year the price of the leading cryptocurrency soared nearly 20-fold, peaking at over $19,000. It’s worth around $6,250 today. The boom brought forth many imitators, including ethereum and dogecoin. Bitcoin even has its own offshoots or forks, as they are called, bitcoin gold and bitcoin cash.

At a time when central banks with their negative rates and bloated balance sheets have undermined confidence in traditional money, it’s not surprising that people should look for alternatives. But these new “currencies” couldn’t be used to buy much in the way of goods or services or to pay taxes. Bitcoin’s technology is far too slow and energy-consuming for such practical purposes. Like the California gold prospector’s storied tin of rancid sardines, bitcoin is good only for trading.

This collection of bubbles has pushed U.S. household net worth to a record $100 trillion, the Fed reported in June. As a share of GDP, Americans are now richer than they were at the peak of the dot-com bubble and the real-estate bubble, according to the Fed. But this is not real wealth derived from savings and investment, both of which have languished in recent years. It is merely the illusion of wealth.

Former Treasury Secretary Larry Summers once observed the American economy only expands when bubbles are inflating. Both U.S. corporate profits and GDP growth are responding to changes in household net worth. It should be the other way around. Yellen was wrong. The United States is a “bubble economy”, no sounder in its fundamentals than the one which collapsed in the subprime debacle.

Since the interest rate discounts future cash flows, ultralow rates have had an outsized impact on investments whose income lies far out in the future, whether through technology companies or 100-year Austrian bonds (sold in September 2017 for a yield of just 2.1 percent). The crypto carnival could only have occurred at a time when interest rates globally were hovering close to zero.

Adam Smith would have understood this well enough. No bubble lasts forever. The main justification for the elevated level of the S&P 500 Index is that long-term interest rates remain low. But the relationship between bond and equity yields isn’t stable over time. If the Fed keeps on tightening, or if inflation breaks out and bondholders take fright, this latest and perhaps greatest of bubbles will also come to burst.

The Zombies

The economy is like a rubber ball. The harder it hits the ground, the faster it bounces back. That’s what normally happens. After the Lehman Brothers bankruptcy, Western economies experienced their deepest contraction since the 1930s. Yet their subsequent recovery was decidedly lacklustre. Soon after, the markets witnessed a startling rise in the number of zombie firms – marginal businesses that appear to feed and multiply on an unchanging diet of cheap capital.

It’s no secret why economies normally rebound after sharp contractions. During a downturn, many companies restructure and loss-making businesses hit the wall. As a result, capital and workers are reallocated to more productive uses. Outdated machines and old-fashioned practices are replaced by the latest technologies and new forms of organisation. More efficient businesses can invest more and produce jobs. Business failures are essential to the recovery. As the saying goes, “capitalism without bankruptcy is like Christianity without hell”. This is how famed Austrian economist Joseph Schumpeter’s creative destruction, the driving force of capitalism, is supposed to operate.

The rate of interest plays a vital role in this process. The “true function of interest”, wrote Schumpeter, is as a “brake or governor” on economic activity. By setting a hurdle rate for businesses, interest rations the use of capital. Interest sets the tempo for economic activity, says James Grant of Grant’s Interest-Rate Observer. It is like the shot clock in basketball, he argues. When the clock is ticking, there’s no dawdling. During a credit crunch, interest rates spike and creative destruction goes into overdrive. “The riches of nations can be measured by the violence of the crises they experience”, observed Clément Juglar, a 19th century economist who studied business cycles.

During the global financial crisis, interest rates on corporate debt spiked. In November 2008, the yield on U.S. junk bonds topped 20 percent. Then the Federal Reserve went into action: expanding its balance sheet, cutting the Fed funds rate to zero, underwriting toxic loans and lending money to investors to buy up distressed debt. Those panic rates soon disappeared. Once the economy recovered, credit watchers noticed something surprising. Over the course of the recession, the cumulative default rate on junk bonds amounted to just 17 percent, around half the level of the two previous downturns. “The Fed’s extraordinary intervention”, opined high-yield analyst Martin Fridson, “enabled companies [to survive] that should have failed”.

The low level of corporate failures might appear a boon. But in the past decade, U.S. productivity growth collapsed to below half its postwar average. New business formation, although recovering, has created fewer new jobs than in past upswings, according to the Bureau of Labor Statistics. The U.S. economy operated for years with excess capacity, yet fewer firms than in similar periods in the past went bust. Even though corporate interest costs had never been lower, a rising number of American companies had trouble servicing their debts. These are the corporate zombies.

Among rich nations, the OECD in 2016 estimated that 10 percent of firms qualified as zombies. For many reasons, these creatures are bad for economic growth: they invest less and create fewer jobs; they crowd out more efficient businesses and act as a barrier to entry for new firms; when industries are dominated by zombies, profitability declines and new investment is discouraged; weighed down with these firms’ bad debts, banks are hindered from making fresh loans. “When too many resources are stuck in low productivity areas and in zombie businesses”, writes economist Phil Mullan, “then the potential for the wider positive impact of particular innovative business investments will be frustrated”. And without productivity growth, there can be no sustained growth in worker incomes.

In the post-Lehman period, a close relationship exists between the rise in the number and survival rate of zombies and the decline in interest rates, according to the Bank for International Settlements. This phenomenon was first observed in 1990s Japan after the collapse of its “bubble economy” at around the time when the Bank of Japan inaugurated its zero-interest rate policy. Zombies survive for longer nowadays, says the BIS, because they face less pressure to reduce debt.

This problem has not been confined to the United States. Europe has suffered an even worse infestation. Italy has had some of the worst cases. Clothing retailer Stefanel is a prime example. Beaten up by strong competitors, such as Spanish fashion house Zara, Stefanel has produced a string of losses and faced several debt restructurings over the last decade. Still the Veneto-based firm clings onto life – its shares down 70 percent since 2014 – thanks to loan forbearance from its banks and to the ECB’s negative interest rates. Zombies are largely responsible for the mountain of nonperforming loans on the balance sheets of Italian banks, among them Stefanel creditor Monte dei Paschi di Siena.

It is conventional wisdom in policymaking circles that a repeat of the Great Depression must be avoided at all costs. That was the rationale for the great monetary experiments of the past decade. Yet contrary to popular lore, the Great Depression was not an unmitigated disaster. Nearly a quarter of a million businesses failed but the survivors, in industries such as auto-manufacturing and aerospace, were given a clear field to invest in new more productive technologies. Economist Alexander Field describes the 1930s as the “most technologically progressive decade of the century”. In the following decade, U.S. economic output returned to its pre-1929 trend. For the postwar generation of Americans, it was as if the depression had never happened.

We may not be so lucky this time. A recent paper by former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard points out that U.S. economic output (per working-age adult) was on course to recover by less than in the years after the 1929 crash. This year, economic growth has picked up and wages are also rising. But should this “Trump Bump” collapse, then the verdict of history may well be that central bankers after Lehman saved the world from another Great Depression – only to deliver the Great Stagnation.

 

*Edward Chancellor is a financial historian, investment strategist and journalist. His book “Devil take the hindmost: A history of financial speculation” was a New York Times Notable Book of the Year.