Date created:24/2/04
Last modified:24/2/04
Maintained by: John Quiggin
John Quiggin

Bonds the key to balance

Australian Financial Review

15 January 2003.

The idea of bubbles in asset prices is a troublesome one for economists. To say that there is a bubble in the price of some asset is to claim that the relevant financial market is not doing its job properly. In the atmosphere of uncritical reverence for 'the markets' that prevailing during most of the 1980s and 1990s, such a claim was unthinkable for all but a handful of heretics (Will rational bubbles fall on the infallible markets ?', AFR, 24 Jun , 1994.)

Even now that a more measured view has been restored, the suggestion that market prices for assets are unsustainable raises what American economist Deirdre McCloskey has called 'the American question' - 'if you're so smart, why aren't you rich?'. To make the point more explicitly, if asset prices are out of line with economic fundamentals, why don't economists and others who can see this back their judgement in the markets and make large speculative profits. This argument is the cornerstone of the famous 'efficient markets hypothesis'.

The now-standard response is usually attributed to the great economist and successful speculator, John Maynard Keynes (though there is no evidence that he actually said it) and states ''the market can stay irrational longer than you can stay solvent'. This point is illustrated by the experience of the greatest speculator of all, George Soros, who bet heavily, in 1998 and 1999, that the NASDAQ stock market was overvalued.

Soros was right, but the market kept on rising, and he was forced to liquidate his short positions. By the time the market turned down in April 2000, Soros had lost billions of dollars. As one of the many economists who shared Soros' view of the dotcom mania (Don't overrate E-commerce, AFR,,8 April 1999), I was glad to have stayed on the sidelines, although I did switch my superannuation strategy away from overvalued US shares.

The same issues arose in relation to the US dollar bubble that ended about a year ago. Although any competent economist could see that the US dollar was grossly overvalued ('US dollar needs a pasting',AFR, 29 March 2001.), the currency was supported by the stated 'strong dollar' policy of the Clinton and Bush administrations, and the evident market belief that this policy meant something. Once again, a lot of money was lost by those who were prematurely right in their belief that the US dollar must depreciate.

These are not the only examples of bursting bubbles that have shaken faith in the efficient markets hypothesis. Real estate bubbles have burst in Tokyo and Hong Kong, and more recently in the Netherlands. Something similar may well occur in Australia some time in the next year. However, the local nature of real estate markets means that, in global terms, the impact of bubbles is modest.

The asset price market that is of most concern is the one that has supported the real estate boom, namely the market for long-term bonds, and particularly for US government bonds. On any assessment of the economic fundamentals, the interest rate on such bonds should be a lot higher than it is.
Looking specifically at the US, foreign holders of US government debt have already taken heavy, and predictable, losses as a result of the depreciation of the last year. Given that the US has a huge current account deficit, which appears to reflect a growing comparative disadvantage in the traded goods sector, there seems to be room for further real depreciation.

Moreover, the massive deterioration in the fiscal position of the US government under the Bush Administration, and the looming crises in Social Security and Medicare/Medicaid must increase the risk that a future government will take the easy route of resolving its debt problems by resort to the printing press. All of this suggests that, rather than paying lower long-term interest rates than other developed countries, the US government should be paying higher rates.
There is, however, a more fundamental problem. All around the English-speaking world, rates of household saving have been plummeting. In Australia, they are actually negative. This decline is directly attributable to historically low real and nominal interest rates and the capital gains they have generated.

Unsustainable levels of current consumption imply that the price of future consumption (that is, the bond price) is too high. Eventually, the restoration of equilibrium must require an reduction in bond prices, that is, an increase in real long-term interest rates. Although that would not immediately affect most Australian borrowers, short-term interest cannot be held low indefinitely if long term rates are rising.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

Read more articles from John Quiggin's home page

Go to John Quiggin's Weblog