The world economy has witnessed a phenomenal rise in asset prices across all asset classes in the last four years. There are a lot of bubbles floating around. Be it World Equities, US treasuries, Commodities, gold, Crude oil etc. It has generated huge exuberance and has led everyone to believe that we are in a totally new economic era derived from Globalisation. At the same time it has got a few economic think tanks worried.
The most accepted reason for the current asset inflation is “Liquidity”. But no one has yet come up with a proper explanation as to what the word really means. And how long will this liquidity persist in the world economy. The unlocking of this query would help us in guessing whether we are truly in a new economic era or we are witnessing an epic asset bubble.
Two reasons can be associated with this phenomenon. First being the Depreciation of Dollar and Second being Debt.
Depreciation of Dollar:
Dollar has been inherently weak for years now. Economists had been bearish on the Dollar in the late 1990’s. But Dollar never actually depreciated against other currencies. The reason for this was the exporting nations of Asia and South America, who artificially held back their currency to support the Dollar and their exports in turn. Especially China which has been constantly running trade surpluses had till recently not allowed the Yuan to appreciate against the dollar.
So these economies artificially depreciated the value of their currency against an inherently weak dollar. The result of this was that, the purchasing power of these currencies against assets went down thus leading to asset inflation.
Debt:
Banking system is known for its ability to create money through credit. There have been a lot of innovations that were introduced in the past decade which has revolutionized the way credit is given and the way it can be availed. Credit derivatives and Securitisation of debt are two examples of these innovations.
In case of Securitisation of Debt, a lender converts his advances into securities which are purchased by investors. So the lender receives money against these securities which he uses to make further advances. This process continues till the lender faces the statutory hurdles. In the process the lender ends up creating money in the economy which is far more substantial than the money created by the “Classic Banking System”.
If we add these two things together what we get is first of all - weak cash and secondly -too much of it. Thus weak cash makes assets expensive and the excess cash chases these assets further inflating their prices.
How long can this continue?
Dollar has started depreciating against the Asian currencies like the Yuan and Rupee. Thus pressure from this angle is somewhat deteriorating. But Debt has still not moderated. The recent debacle in the Subprime mortgage in the US has still not smartened the regulators. So this aspect of the equation still prevails.
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