A punishing wave of default and bankruptcy always follows toxic cases of asset price inflation.
ASSET price inflation is different from consumer price inflation, which people know as rising prices in general, like for groceries, clothes and wages. Consumer price inflation starts when central banks print money faster than the economy can create wealth.
Asset price inflation is different, but related. It happens when prices of real estate, stocks, bonds, art, gold or collectibles rise out of proportion to consumer price inflation, when asset prices don’t just keep up with inflation, but far outpace it. As a result, asset prices no longer correspond to interest rates and output, and seem excessive.
While possible during inflationary times, asset price inflation thrives when consumer price inflation is low or subsiding. That’s because low consumer price inflation and low interest rates travel together — and low interest rates permit asset price inflation.
The illusion of easy money
Technically, inflation is not rising prices but falling purchasing power. More dollars per condo means each dollar has less condo behind it. But the process of asset price inflation creates a convincing illusion that as prices rise, wealth increases — wealth without work, wealth from merely owning something.
Indeed, some people do get rich from asset price inflation. Advisors, agents, developers, and dealers, especially those who charge a percentage of the inflating asset, can become astonishingly wealthy. Owners of the asset, those who get on board early, ride it for a while, and hop off with a good profit, do well. Some ride free, getting a large portion of the asset as a benefit of employment, in the form of stock options.
But most people do not gain much from asset price inflation. They buy the asset, and often overpay for it; they own the asset, but they don’t sell it at peak values, and so they don’t benefit from inflated prices. Or when they do sell it, they’re forced by circumstances to dump it at unfavourable prices. Or they sell it in disgust, at the bottom of a long slide.
Is it toxic?
There are two kinds of asset price inflation. One kind is fairly benign, like what happened with gold in the late 1970s. The other kind is toxic, like the inflation of Japanese land and stock prices in the 1980s. Toxic asset price inflation ends badly — in a once-in-a-lifetime slump.
The mild kind ranges from the harmless fever for collectibles like Beanie Babies to painful investment fads like resource stocks. When mild asset price inflation stops, prices collapse. In a short time the former object of desire is cast aside, while the economy shrugs and carries on.
The majority of bull markets fall into this category. When an overpriced stock market falls, there may be a mild recession, but in a few months both the market and the economy recover and go on to new highs.
If the craze involves just one industry, like disk drive manufacturers in the early 1980s, a shake-out and fall from grace lies ahead. In this case, the over-loved asset may wither and fade, but the overall economy will motor on.
The dangerous kind of asset price inflation closely resembles the harmless version. Few investors understand the difference. Once they recognize that prices and mood are out of hand, most observers expect a stock market boom to resolve with an ordinary bear market and a shallow downturn in the business cycle.
Toxic asset price inflation exacts a tougher penalty, in the form of an extended slump, a lost decade, lasting fifteen to twenty or more years. These difficult periods are marked by rolling upmoves and downmoves, recurrent recessions and low investment returns.
Few analysts want to predict an outcome this bleak, or the low mood and lost dreams of the people who will live through the aftermath of toxic asset price inflation.
How do you know if we are headed for serious trouble? Both kinds of asset price inflation feed on themselves in a circular fashion, both require leverage to sustain them, and both kinds bewitch the general public and institutional investors alike. What makes one so destructive — and the other not?
The proliferation of credit
The difference is the engagement of the credit system. In an ordinary boom, it’s normal to see relaxed credit standards. Business and credit are old friends. It’s not unusual to borrow money to build a factory, hire the workers, order the raw materials, or ship the final product. When business is good, lending is good.
Investors know a thing or two about borrowing money themselves. While imprudent, using other people’s money to speculate in stocks or real estate is common. Lenders are game, as long as they are first in line to claim their security and you are left with the loss.
But security is relative, not absolute. If land prices double in five years, but rents stay the same, intrinsic values have not changed. Lenders don’t have double security. The increase could be temporary, or unrealizable. And to the extent that prices reflect the hand of debt, it’s fictitious.
Yet as prices rise, investors and lenders feel there is nothing wrong. All is well in the world. The future looks bright, so as asset prices inflate, lending gets easier and loans get bigger.
For a while, it seems like it will never end. The higher asset prices go, the more collateral you create, the less risk you perceive, the greater the urgency to borrow, and the faster the lender wants to do the business. As long as new money keeps coming into the center, drawn in from the edges of a growing circle, the asset inflates.
Still, when friendly lending progresses to outright loan fever — no down-payment loans, loans without security, new loans to pay the interest on old loans — the end is near.
Even though the potential credit supply is equal to the value of all property and securities, and expands as each new loan inflates asset prices and collateral value, there is a finite limit to how much debt can be serviced, repaid, or refinanced.
When large numbers of borrowers desperately seek new loans to repay their old loans, the end is here. And because the edifice of debt stands on grossly inflated assets, illiquid assets, and assets that produce little income, the end is brutal.
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