When Bubbles Collide

Speculative bubbles have a long history. So do comparisons of the modern economy with earlier ones (tulipmania, the south sea bubble, and the Mississipi bubble, for example, the details of which Charles Mackay covered in his classic book, Extraordinary Popular Delusions and the Madness of Crowds.)

In our own era, however, a new pattern seems to have arisen: instead of occasional bubbles, the steady and predictable appearance of one after the next. In recent years, the American and global economies have lurched between a real estate bubble in the 1980s (that led to the 1991 meltdown), the developing economy bubble that led to the Asian financial crisis in 1998, the Internet bubble from 1998 to 2000 and the now deflating housing bubble of the 2000s. Each time, an asset class becomes extraordinarly attractive, money flows in and then the music stops. And then it starts all over again as it appears to be doing, now, with the latest bubble in commodities.

The news Friday and over the weekend was of the continuing collapse of one bubble, the housing one and the rise of a new bubble in commodities. On Friday, talk swirled of the collapse of IndyMac Bancorp and the potential collapse of Fannie Mae and Freddie Mac. Over the weekend, the Fed and the Treasury came up with a rescue plan for the latter which will be tested today. Meanwhile, commodities prices continued their crazed rise. As always, people continue to debate whether the commodities bubble is based on fundamentals or is speculative. As always, they forget that it can be both for bubbles almost always start out with something real only to balloon and pop.

Two interesting articles today shed light on this not so new chapter of the global economy. One by Edward Hadas in the Journal points out that investment funds dedicatd to commodities have soared from $70 billion to $220 billion in the last three years. This added liquidity has exacerbated the impact on prices from rising demand in India and China. Whereas in oil markets, a plausible case can be made for a long term supply demand imbalance, the doubling of the price of Appalachian coal--consumed largely in the US--this year points to financial causes.

The ballooning in any market comes not from the buyers--who are simply doing what they ought to do--but from the presence of immense liquidity in the financial system, that encourages the buyers to outbid one another for the product. This is what happened in housing--buyers bid up prices on expectations they would continue to increase forever--thanks to the enabling factor of the financial markets. Now it's happening in commodities. It is the liquidity--or easy money--that makes huge bubbles out of real demand.

A second piece by Wolfgang Munchau in today's FT, observes that in the past, the vehicle for reining in excess liquidity was the G-8 whose finance ministers regularly met to try to keep exchange rates and money flows in balance--not always successfully, but at least regularly. The explosion of savings and therefore liquidity in the developing world and oil belt, however, means that the primary source of liquidity today (over 80% of global capital) lies outside the G-8. There is no central mechanism for controlling liquidity which has also soared as billions of Chinese, Indian and others save one third to one half their annual earnings for retirement. It is this money that China, in essence, has lent to Americans to buy its goods at Wal-Mart. The Chinese end up with trillions in US bonds and Americans end up with goods in their garages. However, that's not quite the end because some portion of this liquidity ends up searching for high returns in the next, big thing or bubble.

A saner approach to things would have been for the Chinese currency to appreciate against the dollar, so that we would have bought less Chinese stuff and China would have accumulated less dollars. However, there is currently no good mechanism to rein in the liquidity or keep exchange rates in balance. Absent that, the default mechanism is boom bust, the ballooning of a new bubble every few years and then its bursting.

There is usually a small silver lining to this cloud. With each bubble, large amount of capital get spent on the asset class in question--office buildings in Dallas in the the 1980s, hotels in Bangkok in the 1990s, fiber optics in the US in the 1990s and McMansions across America in the 2000s. However the consequences for ordinary families can be severe when the bust comes. This time around, many Americans will lose their homes.

The current round of high commodity prices will have effects of their own. They are already stimulating increased investment in commodities--private equity funds are buying up and re-opening old mines--and high energy prices may drive investment in new renewable fuel technologies. The latter would have the benefit of freeing us from future commodities-based inflation.

However, with the S&P commodities index up 71% in the last year, it is increasingly clear that we are in a bubble with all that entails. And if history is a guide--and in this case it surely is--once the world gets through the housing bubble, we should anticipate coping with the consequences of the next bursted bubble in commodities.