Tuesday, June 29, 2004

Stephen King at The Independent can see the termites eating at the foundation of Global Recovery Estates.
  • the PE ratio of the US equity market is far above its long-term average; "equities today offer the same kind of excellent value that was available in 1929";
  • housing bubbles in the UK and much of the US;
  • the massive US current account deficit;
King continues:
These three oddities suggest that bubbly behaviour still persists. People are still prepared to pay more than before for owning equities. They're prepared to pay a lot more than before to own houses. And they're prepared to carry on borrowing in ways that we've never seen before.

At a pinch, it might be just about possible to justify this behaviour. Those who seek to do so rely on two arguments. First, they point out that we're seeing a supply-side revolution which is transforming the world economy, driven by new technologies and the arrival of new economic powerhouses such as China. If this means stronger long-term growth, that might justify higher asset prices today than in the past.

Their second argument relies on the observation that interest rates are quite a lot lower today than they used to be. A lower discount rate justifies higher asset valuations - hence more expensive shares and houses - and also paves the way for higher sustainable levels of debt.

These arguments are all very well but, in my view, they don't really make an awful lot of sense
Indeed, the first argument is basically a rehash of "New Economy" thinking of the late 1990s. The second is just plain wrong. Indeed nominal short-term interest rates are incredibly low. But real long-term rates which one would think informs purchases of equities, houses, and durable consumer goods are not particularly low at all. King recommends a "weak dollar" policy but fails to show just how weak the USD must get to start chipping away at these imbalances. After all, a 13% decline over the last two years didn't make a dent in the current account deficit. With a global economy still highly dependent on US consumption and East Asian central banks still determined to buy dollars no matter how poor an investment, a weak dollar policy faces one hell of a Sisyphean hill to climb.

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