Financial markets attempt to stop the runaway money train

In the past few weeks, the world�s financial markets have begun to worry again about the huge amount of money sloshing around the globe. So many assets have risen in value simply because there are billions of dollars of excess money seeping into every nook and cranny of the financial system. Where is the money coming from and how can central banks manage the asset bubbles building?

No-one wants a global fall in asset values which might precipitate a global recession, so the question is how do the world�s central banks deflate housing markets, commodity markets, stock markets and emerging markets in an orderly fashion. This is a very difficult act and one that has not been managed before.

Typically, when the world interest rates cycle turns, investors get burnt badly.

Further, because of the integration of the financial markets, a tiny change in one part of the world can have major unforeseen consequences in another part of the globe.

For example, this week the stock and property markets of the Gulf States took a hammering. In one day, the Dubai stock exchange fell by 11 per cent.

Why was this? Did oil prices fall or some political event in the region trigger investor panic? No, it was because (and this might be of interest to those hundreds of Irish people buying property in Dubai) the Bank of Japan indicated that it might be putting interest rates up (minutely) by the end of the year.

What has this got to do with Dubai?

Well nothing really, until we appreciate that the bull market in the Gulf States was in part financed by what are called in the business ��carry trades��. This is where an investor will borrow in Yen, because the interest rates are effectively zero, and finance investments in a rising market like Dubai.

The stocks are used as collateral. The higher the Dubai market goes, the more money will be lent to the investor because the greater the value of his collateral. At the first suggestion that Japanese rates might rise, the investor sells his Dubai position despite the fact that nothing negative in Dubai has occurred to prompt this. And, as the stock market falls, more money is withdrawn because the ��value�� of the collateral has fallen.

So the more borrowed we are globally, the more sensitive assets are to minute changes in faraway central bank policy.

Given what occurred in Dubai this week, can you imagine what might happen if the ECB, Federal Reserve and Bank of Japan were to raise interest rates at the same time? Obviously some assets are more fragile than others, but there is a real chance of global panic.

The nub of the problem is the way in which banks (lenders) value collateral in a boom. There is an inbuilt self-propelling mechanism that exacerbates the upswing and the downturn.

As the ��value�� of the collateral rises, the bank feels that it is prudent to lend more money against that asset. So in the case of Dubai, as long as the stock market was rising, banks kept lending to investors, who kept placing bets. We can see the same thing happening here in our property market.

Let�s look at the example of a house worth �400,000. It is used as collateral to borrow �370,000 to buy another property for investment. The extra �370,000 goes into the system.

The golden rule of monetary economics is that the more money in the system, the greater the upward price pressure on all other things. Thus, the extra cash sloshing around in the system puts upward price pressure on houses because there is too much money chasing too few houses. This makes the original collateral now increase in ��value�� to �430,000. And so on. The bank extends another loan on the same collateral, failing to distinguish the chicken from the egg. In time the balance sheet plays tricks on the banks.

Because of this self-propelling mechanism, the system has no break and it is impossible for it to slowdown of its own accord. Not only does the machine not have a reverse gear, it has no neutral and feels like a car constantly revved in third gear. Critically, these phenomena cause booms and troughs to be amplified.

So what can be done? An interesting solution might be for our banks, and banks around the world, to adopt a simple moving average of the asset price upon which to base their lending rather than the price today, which is the case at the moment. So, for example, here the central bank could advise the commercial banks to use a 10-year moving average of house prices. This would reflect a typical asset price cycle.

It would have the advantage of stabilising credit swings. Credit expansion (and house or asset prices increases) would be mitigated in boom times, as would the pressure to withdraw loans and mortgages when things turn sour. This approach would smooth the asset cycle and with it the peaks and troughs in prices.

In the course of the next few years, the central banks around the world have to grapple with the idea that the most serious consequence of today�s credit bonanza is not inflation � as was the case in the 1970s – but large rises and falls in asset prices.

The experience in Dubai this week suggests that we do not understand the fragility of the market. This sensitivity is particularly worrisome when the United States continues to print paper money to pay for its imports. The recipients of this paper money – US dollar denominated T-bills – are those countries with a large trade surplus with the US, namely, China, Japan and Germany.

As long as the US continues to live in hoc, cheap money will flood the market, causing asset prices to rise. But as we saw in Dubai, this can change rapidly, leading to sharp falls.

What might happen if the countries which at the moment are lending to the US decided that they no longer wished to do so? Or what if they demanded a higher rate of interest/return for the pleasure of holding American assets? This could cause wild swings in asset prices around the globe affecting the price of our houses, our pensions and our general prosperity.

Surely a better outcome would be to introduce a ten-year moving average to govern the value of collateral that determines how much can be lent. This might be dull, might not give us the roller coaster ride that some investors thrive on, but it would protect the average punter, which is what should be the primary aim of a strong financial system.