Are we in a financial bubble? Yes of course, we always are, but this one is different!

Many will be forgiven for feeling and being confused by the constant divergent chatter over market bubbles. 

Yes, we are in a bubble: I believe an extreme one in fact, but the natural state of the financial world relative to the economic is always one of a bubble; asset markets are always discounting the future, and the money supply that creates demand for assets and also goods and services has been growing for some time, as has the economy.  If a market is priced at x times historical earnings it is discounting future earnings and by doing so providing a valuable medium, or at least should be, for financing new investment and for facilitating the transfer of assets.   As the economy grows, so will assets and their prices and so will the bubble….and the bubble is the difference between now and future cash flows and the pricing of those cash flows. 

As long as economic growth, money supply and asset markets expand at roughly the same rate there will be no problem; occasionally asset markets and economies diverge, creating periods of over valuation or market shocks (an under valuation) as demand for assets and money respond.   But these periods of market corrections and crashes are not necessarily a bursting of a bubble per se, merely the bathwater moving from one side to the other.   A bubble bursts when its matter dissipates.

What we have at the moment is the end of a long period of divergence, a period where the supply of broad money relative to economic growth in key economies has been out of balance (and where this imbalance has even been supported post crisis by QE generated deposits) and where the demand for assets relative to growth and various other metrics is likewise.  A number of other imbalances have accumulated that have exacerbated this divergence, namely the well documented growth in income and wealth inequality and the consumption/production/investment imbalances between developed and developing economies.   Part of the divergence between asset values (low IRs, QE etc) and growth is due to aging populations, slowing population growth and in a number of key economies, actual declines in population.   The amount of productive capital in terms of its accumulation, and possibly also its amount, needed to sustain demand in the lower growth environ is less than required in the higher growth paradigm.  

But as imbalances started to accumulate and growth started to slow, interest rates fell to accommodate and stimulate growth, and in so doing debt, asset values and asset focussed money supply growth started to diverge from growth and incomes, and grew at a higher rate than the underlying economic frame.  Interest rates no longer moved because of the risk of recession but because of the risk of asset prices declines on the financial system and economic activity and because of the impact of higher IRs on the ability of the economy to sustain higher debt/asset levels.  This is the chokehold I have referred to in other posts.  

People may say, “well, individuals have called the bubble for years, yet it has not burst”, as if this is proof that a bubble does not exist.  Unfortunately a bubbles grows because the environment continues to support its growth.  Bubbles do not burst simply because they exist but burst because the flows can no longer sustain the divergence.

A key part of the modern economic construct is the financial system and the stability of the financial system depends to a large extent on the stability of asset values: declining asset values impact debt valuation, and debt defaults impact the financial system as we saw between 2008/2009 in the US.

We are in a dangerous bubble now not because of key structural imbalances and a weakening growth frame, but because the relationship between asset values, debt and growth have not been allowed to fully readjust.   What used to be a natural financial frame around the economic has become a too big to fail edifice.  The bubble that used to naturally envelop the frame and help foster growth is now a burden, a constraint and a significant additional risk to growth.

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