Panel, Conference Presentation
2014 London Summit - Have Central Banks Created an Asset Bubble?
Milken InstituteWillem Buiter, Ousmène Mandeng, Robert Seminara, Zak Summerscale, Staci Warden, David Zervos, Wilhelm Stelzenmüller
- Central banks are viewed by some participants as contributors to asset bubbles driven by private sector denial of risk and the search for yield in a zero or negative risk-free rate environment, while others argue the private sector is the sole creator of bubbles.
- A credit bubble is identified in public markets supported by collective denial of sovereign, banking, and enterprise credit risks, with investment grade interest rate spreads at bubble levels of 50-60 basis points rather than the acceptable 100-120 basis points.
- Equity overvaluation is characterized as a reflection of the credit bubble and artificially low discount rates rather than a standalone equity bubble, with the risk-free rate reflecting negative real neutral rates while bubbles reside in risk spreads.
- The US economy is estimated to remain approximately 18% below its potential output trajectory following the 2008 crisis, with 3.6 trillion in incremental Federal Reserve liquidity failing to generate commensurate growth in consumption or capital expenditure.
- Global central banks face a cycle of lowering rates and expanding balance sheets to manage crises while achieving diminishing returns, risking the misallocation of resources in export, construction, and financial sectors.
- Policymakers are considering "leaning against" asset price bubbles despite significant uncertainty in financial stability indicators and macroeconomic models that lack a fully articulated financial sector.
- Implementation of macroprudential policies faces political sensitivity and may clog the monetary transmission mechanism, while raising interest rates during a bubble could worsen the situation by violating the "Hippocratic Oath" of monetary policy.
- There is a consensus that the effectiveness of current monetary and fiscal policies is questionable, highlighted by the UK seeing a 50% increase in government debt post-2008 with only 1.5% cumulative real output growth.
- The risk of policy error is deemed tremendous due to the dominance of public debt and monetary expansion, with fears that central banks may exacerbate existing problems under current frameworks.
- A shift from rules-based to incentive-based frameworks is suggested to handle emerging market integration, noting that countries implementing monetary cheating (devaluation/QE) historically exit crises sooner.
- The issuance of "pick-up" bonds and covenant-light loans is at all-time records, signaling significant froth in the shadow banking sector.
- Total system credit in the US is currently below 340% of GDP, remaining below pre-crisis peaks of 360%, while emerging markets and Europe are heavily over-levered in corporate credit and government debt respectively.
- Private equity deals are transacting at average multiples of 10 times EBITDA, matching leverage levels seen in 2007-2008, though European asset multiples are converging with US levels indicating undifferentiated risk.
- Pension funds and investors face pressure to achieve 7-8% returns in a low-rate environment, leading them to ignore risk, while high-yield spreads of 450-500 basis points suggest the market is not in a bubble compared to the 2006-2007 period.
- Market participants expect idiosyncratic failures of over-levered companies rather than a single market-wide trigger, though a market trigger would cause severe losses given that volatility is not currently priced.
- The expectation of central bank bailouts creates a "free option" that encourages reckless credit underwriting, while recent UK deals like Phones4U have demonstrated instances of credit deals acting as equity in disguise.
- ECB actions are expected to trigger a massive risk rally but will not solve Europe's structural problems, with a return to quantitative easing forcing investors to take more risk without addressing underlying issues in Southern Europe.
- Monetary policy alone cannot create a sustainable recovery in Southern Europe without creating a bubble in Germany, and the Euro area faces a risk of cyclical stagnation turning into secular stagnation.
- Italy's public debt is considered unsustainable without a supply-side revolution removing employment protection policies, and Euro depreciation is unlikely to sufficiently boost exports to resolve regional imbalances.
- Current US macroprudential policies focus on stronger institutions like capital ratios rather than counter-cyclical measures, with some arguments suggesting the Fed should raise rates for financial stability even if inflation and employment mandates are not met.
- Risk premiums are currently compressed, with risks that should price at 500 basis points trading at 200 basis points, and low interest rates are increasing the danger of bubbles by inducing cognitive dissonance about risk among private sector actors.
- European SMEs are unwilling to borrow due to a lack of growth visibility regardless of credit-enhancing policies, while private equity funds are currently selling more assets than deploying to avoid holding bad positions when the market turns.
- Recent private equity exit multiples averaged between 9 and 10 times EBITDA, with new investments made at 6 to 7 times EBITDA, and deal sizes are smaller than in 2007-2008, potentially reducing systemic crash risk.
- The debate regarding whether central banks create asset bubbles is expected to continue for many years, with the risk that central banks will exacerbate problems if they continue current policy frameworks.