The Hindu Business Line : Asset bubbles: Central banks can call the shots

A much-bandied about phrase in recent times, when talking about financial markets, is the abundance of `global liquidity'. Most explanations of the current huge run-up in asset prices attribute it to the system being awash with liquidity.

But what exactly does it mean? Lots of spare cash swirling around the world seeking a home? Central banks pumping money liberally into their economies? And, most important, is liquidity central bank independent?

The boom in stock markets, property and precious metals certainly suggests strong asset demand on a scale rarely seen before. Also striking is the synchronisation of elevated markets across both rich as well as emerging economies. Forecasts point to another stellar year for growth.

What's the driver? What are the risks? Have the old rules broken down? In this brave new world, how can we get policy right?

Savings glut

Start with the Fed Chairman, Mr Ben Bernanke. Some time ago, when asked why US bond yields were low despite the Fed continuously increasing interest rates, he thought it was because of a global `savings glut'.

Asia was not spending its export surpluses — only lending them to the US, enabling the world's richest country to live well beyond its means. Religions and economics say sinners cannot go unpunished.

But predictions of a triple collapse of the dollar, bonds and Wall Street have gone unfulfilled for so long that many have ceased to take them seriously. Faced with low interest rates and bond yields in their countries, first world investors have moved aggressively into emerging markets. Even as reserve-flush countries, willy-nilly, park their funds in dollar assets, US saving (or what little there is of it) is increasingly finding a home in the very same countries.

Market ill-equipped

Financial markets in emerging economies are ill-equipped to handle the flows. The results are there for all to see — explosion in asset prices and the monetary base as central banks desperately try to fend off domestic currency appreciation and suck out the excess dollars in the system.

There is no question that households the world over are and feel wealthier.

Besides, they can borrow practically for the asking from banks. Enormous global spending power has been unleashed. Historically and sustained low interest rates, coupled with adequate liquidity, have, without doubt, fuelled economic and asset price buoyancy.

The risks clearly are things getting out of hand on the general and asset price fronts. Time was when central banks only worried about `conventional' inflation. Now they must puzzle over the possible asset bubble-inflation connect in shaping policy.

Too much saving and wealth may be chasing too few assets but it is central banks which must deliver the liquidity for prices to go up.

Make no mistake — in this age of global financial integration and plastic money, central banks continue to call the shots. They can still turn the liquidity spigot on and off and make or break markets.

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