September 7, 2009

Bursting the Government Bubble

By Alan Aronoff

In the last decade, we have witnessed the bursting of two bubbles, the stock market bubble driven by internet stocks with unsustainable business models and valuations, and more recently, the private debt bubble that has resulted in the destruction of credit along with real estate values. America is now engaged in the unprecedented growth in government accompanied with unprecedented debt at the federal level. The Federal Reserve in cooperation with both the Bush Administration in its final days and now the Obama administration is propping up the credit markets with over $1.0T including the TARP funds, and open market purchases of the US debt obligations. Can the too big to fail hypothesis for the big banks also be applied to the Federal government?

The table below shows the history of the Japanese Tokyo stock market before and after its bubble burst in 1990.

TOPIX COMPOSITE

Ref: FEB. 9, 2009 = 1000

And, the table below shows the history of the NASDAQ from 1995 to the present.

Bubbles are only possible if the increase in value (stock, home prices) is believed to be secular. This happens in stages. Initial price increases climb a wall of worry, that the prices may have overshot the real market price. If this continues for a while, then we get to a second phase where euphoria creeps into the market psyche causing more and more people to jump into the market thereby causing prices to go higher. At this stage, people rationalize that ‘this time it is different' from the market norms. Eventually, most everyone who wants into the market is in, and there is no demand.

Market pricing is set at the margin, and so with no demand, prices must drop, and precipitously. Prices do not find a bottom until the assets are placed into strong hands that will take the demand out of the market. People who are burned in the collapse of asset pricing will be highly averse to re-entering those markets.

In looking at the NASDAQ market, we see that after nearly a decade since the bubble burst, prices have not recovered. The Japanese TOPIX market bubble burst in 1990, and prices still have not recovered nearly twenty years after the bubble had burst. The TOPIX is at the same price as in 1985. Neither the NASDAQ nor the TOPIX markets had overcome fundamental rational economic principles, and both markets purged the excesses.

There is an analog to market bubbles now occurring in market for the demand for government services.

The Obama agenda is driving secular growth in government size and services as seen in the Stimulus bill, the March budget resolution, cash for clunkers, cash for insurance companies, cash for banks, cash for GM, and potentially a government option for health care. All of these costs for expanded government need to be paid, and so far, this administration has not articulated how to pay for these bills. In any event, large tax increases are needed to fund the growth in services and the debt service (let alone reducing the deficit). The battle for reforming America's health care system exemplifies the wall of worry that proponents of expanded government must climb. Eventually, all bubbles will burst, and there will be a reversion to the mean, that is, the level of government size and services that existed before the bubble. One possible objective of this Administration is to successfully change the nature of America and government in a way such there can be no reversion to the mean. This is the change that Obama hopes to achieve. Bursting bubbles early minimizes dislocation and distortion of the market for government services. The event driving the bursting of the bubble for government services will be either the electorate deciding it cannot or will not pay for these services, or because the inability to sell government bonds or monetize the US debt to pay for these services. And, if political human behavior follows economic human behavior, government services will revert to the mean.

The Obama administration, and Rahm Emmanuel's claim that the financial crisis is not to be wasted has set the stage that will either result in a permanent change in the size and power of the federal government, or it will result in an abrupt end of the growth of government services. In either case, this administration has created an unstable relationship between government and its constituents. Either way, there will be change.