In a globalized world, with few barriers to capital flows, investors around the world can bid up prices for stocks, bonds and real estate in local markets from New York to Shanghai.
Central banks have fueled these purchases with record low interest rates and by entering the bond market as major buyers themselves
Largely as a result, global financial assets (including only stocks and bonds) are worth $280 trillion and amount to about 330% of global GDP, up from $12 trillion and just 110% in 1980.
Traditionally, economists have looked for trouble in the economy to cause trouble in the markets.
They see no cause for concern when loose financial policy is inflating prices in the markets, as long as consumer prices remain quiet.
Even conservatives who worry about easy money "blowing bubbles" still look mainly for economic threats to the financial markets, rather than the threat that overgrown markets pose to the economy.
But financial markets are now so large, that the tail wags the dog.
A market downturn can easily trigger the next big economic downturn.
Summary:
The general rule is that strong growth is most likely to continue if consumer prices are rising slowly, or even if they are falling as the result of good deflation, driven by strengthening supply network.
In today's globalized economy, in which cross-border competition tends to suppress prices for consumer goods but drive them up for financial assets, watching consumer prices is not enough.
Increasingly, recessions follow instability in the financial market.
To understand how inflation is likely to impact economic growth, keep an eye on stock and house prices too.
Housing bubbles and Stock bubbles fueled by borrowings
Be alert when prices are rising at a pace faster than underlying economic growth for an extended period, particularly for housing.
- Home prices typically rise by about 5% a year.
- This pace speeds up to between 10% and 12% in the two years before a period of financial distress.
- Once prices for stocks or housing rise sharply above their long-term trend, a subsequent drop in prices of 15% or more signals that the economy is due to face significant pain.
In general, housing bubbles were much less common than stock bubbles but were much more likely to be followed by a recession. The downturn is much more severe if borrowing fuels the bubble.
- When a recession follows a bubble that is not fueled by debt, 5 years later the economy will be 1% to 1.5% smaller than it would have been if the bubble had never occurred.
- If the investors borrow heavily to buy stock, the economy 5 years later will be 4% smaller.
- If they borrow to purchase housing, the economy will be as much as 9% smaller.
