Bubble? What bubble?

 

Matteo Renzi is the 39-year-old John Edwards look-alike who serves as Italy's third consecutive unelected prime minister. He presides over a fractious government whose credit rating is, well, subprime.

And with good reason. Government debt now stands at 133 percent of GDP and has grown worse as liabilities continue to mount amid shrinking output. The Italian economy has contracted in four of the last six years, last year by 1.9 percent, bringing economic activity back to a level slightly below that of 2000. Per capita GDP, a measure of living standards, has eroded to 1996 levels.

This brew of economic sclerosis, political instability and a deeply indebted government ordinarily would spook investors, making them demand a high price for Italian sovereign bonds or to shun them entirely. It hasn't. Investors are snapping up Italian debt at yields that are just above those paid by the U.S. Treasury. On Monday, 10-year Italian bond rates at close were just 9 basis points (0.09 percent) higher than 10-year debt issued by the U.S. Treasury.

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That spread is a bit jarring, especially since the European sovereign debt crisis, still unresolved but in a period of dormancy, came about because investors vastly underestimated the risk of debt issued by Italy, Greece and other nations on Europe's periphery. It was a sovereign debt bubble.

Who would buy an Italian 10-year bond that pays just 2.7 percent when they could get U.S. government bonds for only a slightly higher price? The European Central Bank, of course, albeit indirectly. Private banks, mostly Italian, buy the bonds and then schlep them to the bank's cash-for-trash window, where they swap them for nominally European but essentially German euros. Those euros, though they improve the appearance of the banks' balance sheets, are not finding their way into the broader economy. Households and businesses, according to ISTAT, the Italian government's purveyor of official statistics, continue to face "difficult access to credit."

Exuberance for Italian bonds is but one expression of a global financial market that seems unhinged from economic reality. "It is hard to avoid the sense," the Swiss-based Bank for International Settlements (BIS) wrote in a report last month, "of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally." These markets, the report evocatively notes, are levitating "under the spell of monetary policy."

That spell has been broadly cast. Where the stock bubble of the 1990s was concentrated in the tech sector and the more noxious bubble of the last decade predominantly affected real estate, the price of virtually every variety of asset is unusually high.

"Welcome to the Everything Boom," The New York Times'Neil Irwin wrote this week. "And, quite possibly, the Everything Bubble," where "nearly every asset class is expensive by historical standards." When the price of everything — from Italian bonds to Iowa farmland — is unusually high, there is good reason to believe that capital is being misallocated and that the misallocation is a byproduct of central bank policies, as the BIS has argued. This could well be an asset bubble of unparalleled proportion.

None of which seems to trouble the Federal Reserve. As in the late 1990s and in 2007, it sees no bubbles, only a future of moderate growth, low inflation and reduced joblessness that it believes will result from what it calls its "appropriate policy accommodation."

The Fed says that it will eventually end that accommodative policy. Its third round of quantitative easing may conclude this fall, though it will hold interest rates near zero (where they have been since December 2008) well after it retreats from its bond-buying spree. And it continues to believe that it can in due course raise interest rates to normal levels without roiling financial markets or harming the broader economy.

What could possibly go wrong?

Badger was formerly deputy assistant to the president for legislative affairs, where he helped formulate the George W. Bush administration's policy and legislative strategy.