Watching the Liquidity Bubble for the Big Pop

Yesterday evening, we sat on the edge of our seats.

What was going on? We tried to explain it over dinner to two teenagers:

“It could be the beginning of the end. Central banks and the financial industry have made money very easy to get. People took the money, and naturally, they spent it; they invested it.

“But sooner or later, the lenders will want it back. When that happens, the borrowers will have to scrape around…you know, looking under seat cushions and selling stuff on eBay…to get the cash. And when everyone is trying to raise cash – by selling things – the things they are selling will go down in price, because there are so many of them for sale.

“This makes it harder for the people who are trying pay off their loans to get the money they need. Some of them won’t be able to, so the loans themselves will go bad; they’ll become worthless because they will never be repaid. And so, the lenders themselves will be hurting, because they won’t be getting the money they lent out back. It’s been spent. Or it’s been poorly invested.

“The whole thing gets to be a big mess…because people discover that they don’t have as much money as they thought they did.”

We interrupt the dinner-table conversation with a little more precision. You might have found Tuesday’s worldwide stock market slump shocking or unnerving. But you shouldn’t have found it surprising. There are some threats to your money that are unpredictable – wars, natural disasters, thefts. But there are other menaces that are inevitable, and the inevitable result of a big bubble is a big pop.

Anyone who says he was ‘surprised’ by the big drop in stock prices just wasn’t paying attention.

When was the last bubble that didn’t pop? Never. It has never existed. All bubbles pop. All living things die. All paper currencies become worthless. All empires are destroyed. All politicians lie.

But let us pull away from these eternal verities and look at what has been going on recently. The quantity of money is increasing at a rapid pace. Just this week we discovered that the euro money supply is now going up at its fastest rate in 17 years – nearly 10% per annum. Dollars are increasing at about the same rate. And in India, the money supply is going up at a 21% rate. And yuan? We don’t know, but we bet it would take our breath away.

Why so much money? Because we are in the bubble phase of a credit expansion. And one of the highlights of this period is that the Bank of Japan will lend money at less than 1%. This tempts speculators to enter the ‘carry trade,’ in which yen are borrowed…carried over to dollars or other currencies…and invested in higher-yielding assets.

Anyone with any sense could see that all this fresh and eager money was going to get a lot of people in trouble. And anyone who bothered to read the headlines could see the trouble coming in fast.

Just a couple of days ago, even our erstwhile Fed head, Alan Greenspan himself, warned that the nation could be in recession by the end of the year. Why? Because the housing market was going soft.

Manufacturing is already in recession. Housing looks like it is headed for recession too. January new house sales, for example, were down 16.6% – the sharpest decline in 13 years. Subprime lenders are going broke. And the LA Times says, ‘Mortgage Delinquencies [still] Rising.’

And now the central banks are threatening to pull the plug on this tub of liquidity.

“There is a bubble going on. Investors should be concerned about the risks,” said Cheng Siwei, vice-chairman of China’s National People’s Congress in a January 30th interview with the Financial Times. “But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice,” Cheng warned.

The Bank of Japan warned speculators, too, that they had better watch out. It doubled its puny overnight rates. The Swiss National Bank offered the same warnings: Borrowing was easy, it said; but paying back may not be so easy. The European Central Bank raised rates and said it would raise them again.

If we’re right about things, speculators should be looking to the price of yen like the passengers on the Titanic looking for lifeboats. They borrowed yen. Now they must pay back yen. As they grow worried, we’d expect the price of yen to rise…because they must buy yen in order to pay back their loans. That is exactly what is happening…perhaps only slightly and furtively so far. And that is why we continue to think that yen-based investments will prove surprisingly strong as the credit bubble deflates.

But we are still watching and waiting. Today, the Dow bounced…a modest 50 points. Emerging markets were mixed. The yen rose. If this is not just a pop…but The Pop…we’ll see more speculators run for cover in the days ahead…and the yen will rise.

“But Dad,” said Henry, “if you’re right, there’s a big mess coming and people are going to lose a lot of money. But if people knew there was big mess coming, they’d sell their investments, right?

“But the price of investments hasn’t gone down. So most people must not think you are right. They think you are wrong. So they’re not selling. They’re buying. And if they think you are wrong…and if they are buying…won’t investments continue to go up…?”

“Yes…as long as the money keeps flowing. But there always comes a time when the money gets pinched…or investors get nervous…or the stars enter a new phase – we don’t know exactly what triggers a sell off. But when it comes…you want to be sure you sold off before everyone else.”

Bill Bonner
Markets and Money

Bill Bonner

Bill Bonner

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America’s most respected authorities. Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind Markets and Money.

Bill Bonner

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