Herb Stein famously said that if something cannot go on forever it will stop. He might very well have been talking about today’s everything bubble in U.S. and world financial markets, which has largely been fueled by the Federal Reserve’s extraordinarily easy monetary policy. Tuesday’s Democratic victory in Georgia’s senatorial races could very well prove to be the beginning of the end for today’s financial market excesses. It could be so by pushing up long-term interest rates through yet another round of large-scale budget stimulus.
It would be an understatement to say that we are now experiencing the mother of all bubbles in the world’s financial markets. Never mind that the United States and Europe are in the midst of the darkest of COVID-19 winters, world equity market valuations are at record levels. Indeed, according to the Shiller Cyclically Adjusted Price Earnings measure, today U.S. equity valuations are at around the same level as they were on the eve of the 1929 stock market crash.
Other indications of financial market excess are to be found in the world’s credit markets. U.S. 10-year Treasury yields remain close to their all-time lows while a record $18 trillion of global bonds now near negative interest rates. At the same time, despite having unsustainable public finances, Italy can borrow at negative interest rates and the troubled emerging market economies now can borrow at close to a record low premium over U.S. government bond yields.
Among the main factors driving the U.S. and global financial market bubbles has been the Federal Reserve’s extraordinarily easy monetary policy. One indication of this ease has been the very rapid pace at which the Fed has expanded its balance sheet. While in the wake of the 2008 Lehman bankruptcy, it took Ben Bernanke’s Fed some six years to increase the Fed’s balance sheet by some $3.5 trillion, it has taken Jerome Powell’s Fed less than six months to do the same thing.
Providing yet another leg up to today's lofty U.S. equity valuations has been the unfunded 2017 Trump corporate tax cut. Not only did that tax cut boost post-tax corporate earnings. It also allowed corporations to engage in a lavish round of share buybacks.
The economic significance of yesterday’s Democratic Senate victories in Georgia is that it now gives the Democrats control of both houses of Congress. This will allow President-Elect Joe BidenJoe BidenOvernight Defense & National Security — Milley becomes lightning rod Democrats hope Biden can flip Manchin and Sinema On The Money — Presented by Wells Fargo — Democrats advance tax plan through hurdles MORE to make good on his promise that the recently passed $900 billion budget stimulus package should be viewed as a mere down payment for further substantial budget stimulus. It's only be a matter of time before Congress approves a $2,000 payment to lower income individuals, a substantial spending boost to state and local governments and a marked increase in COVID-related public spending.
Substantially boosting government spending may invite higher long-term interest rates and a weaker dollar. This would seem to be especially so as the U.S. budget deficit reached a record 15 percent of GDP and government debt rose above 100 percent of GDP.
Should long-term U.S. government bond rates indeed rise, investors would no longer feel the need to stretch for yield by piling into riskier assets. That could very well be the trigger for the bursting of the U.S. and world’s asset price bubbles.
One of Joe Biden’s repeated campaign promises was to reverse the Trump corporate tax cut. After Tuesday's Georgia election, he is now in a position to fulfill that promise. This hardly bodes well for the maintenance of today’s very lofty equity valuations.
One has to hope that Janet YellenJanet Louise YellenOn The Money — Presented by Wells Fargo — Democrats advance tax plan through hurdles Yellen presses Democrats on tax enforcement CEOs urge Congress to raise debt limit or risk 'avoidable crisis' MORE, Biden’s nominee for Treasury secretary, understands the extent of today’s U.S. and global financial market bubbles. One also has to hope that she is able to restrain Biden and a Democratically controlled Congress from pursuing an unduly expansive budget policy. If not, we should brace ourselves for a very difficult year ahead in the U.S. and world financial markets.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.