Understanding the distortions created by governments trying to control the markets can help investors win. But buying into a bubble requires knowing when it will burst, for if you get it wrong, it might be like standing downstream when a dam goes
China's Three Gorges dam is a magnificent technological achievement. It stands as testimony to man's continual battle to control the natural forces to avoid disaster and promote growth. Often these efforts backfire. Nature wins. The projects and policies cause more problems than they solve. The Chinese have admitted that the world's largest dam has increased landslides, silting, pollution, and potentially earthquakes. It also might be a factor in the worst drought in 50 years. The same can be said for massive efforts to control markets. In the end, markets win. Understanding the distortions though can help investors win.
In the United States, the Federal Reserve Bank is finally going to end its $600 billion stimulus package known as QE2. QE2 was supposed to help the US economy by keeping interest rates low and encouraging borrowing. It basically failed. It was supposed to help the sluggish housing market, but house prices are worse than before QE2 was started. Both inflation and unemployment are higher now than they were then and economic growth is slower. It is not only the US who has suffered; countries around the world are being impacted by higher prices. Inflation is most likely out of control in two of the world's largest economies, India and China, creating social unrest and hardship for the poor.
But that does not mean that everyone lost. Large investment banks like Goldman Sachs and commodities speculators have done quite well. They have ridden the easy money bubble to more profits. Sadly ordinary investors have not had a similar experience. They pulled $52 billion from the markets and only started to get back in February and April during market tops.
But it wasn't just QE2 that created these mini bubbles. Black cygnets have also been created by the US government including the 'cash for clunkers' which provided an incentive to buy cars and an incentive to buy houses. Both programmes were successful for short periods at boosting sales and prices, at great cost to the taxpayer. Of course, when the incentives were withdrawn, the markets reverted and the bubbles deflated.
One of the greatest bubbles was created in Japan. In the late 1980s, the Japanese Ministry of Finance (MoF) did the Fed one better. They created a huge stock market and real estate bubble. The difference was that their methods of market manipulation went far beyond just monetary stimulus. Since they had greater control over the economy, they were able to manipulate many other aspects. For example, the Ministry of Finance had enormous power over the banks. They were subject to micro-management down to branch openings and senior personnel appointments.
MoF bureaucrats also controlled tax policy. By providing tax exemptions for income put into bank deposits, low or non-existent tax on interest income and walling off Japan's financial system from the outside world, they were able to ensure that vast amounts of capital were available to create an asset bubble. Then by limiting information concerning land prices, they were able to maintain the sentiment of ever-rising land prices. Still, despite all of this manipulation the market won, big time. Japan suffered a crash from which it still has not recovered.
Then we get to China. China does not need to control its banking system through a powerful ministry. It owns its banking system. It used its control over that system to help prevent a meltdown through loans to state-owned companies and local governments. Now, approximately $350 billion of these loans have gone bad. But the banks are flush with money, because China, like Japan, has walled off its financial system from the rest of the world. The only people who seem to be able to invest out of the country are corrupt officials who have been successful in exporting $123.6 billion of ill-gotten gains over a 15-year period, according to a report released by China's central bank. The result is, like Japan, a massive real estate bubble.
In their excellent book, "Japan's Policy Trap", Akio Mikuni and R Taggart Murphy wrote almost a decade ago that "A century-long policy of accumulating production capacity and claims on other countries without regard for profitability or return, has saddled Japan with a huge pile of dollar assets. Those assets can neither be exercised nor exchanged without destroying the political economic base of the Japanese system, yet their sheer weight has defeated every attempt to restart the economy." Sounds a lot like China to me.
For investors, there is great opportunity and great risk when the government fights the market. You know the market will win, but you don't know when. Buying into a bubble requires knowing when it will burst and if you get it wrong, it may be like standing downstream when the dam goes.
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected].)