Morgan Stanley analyst Joachim Fels has penned an analysis of the bubble and crash cycle that could have been written by an Austrian economist. Fels has a very good idea of the way that injections of inflation by the central banks works its way into asset markets, causing bubbles and economic distortions.
The heroes and the villains in this story are the central banks, in my view. They have unleashed serial bubbles, time and again, by pumping excess liquidity into increasingly deregulated asset markets. And, over time, central bankers have become prisoners of their own (or their predecessor’s) past actions. To address the serial bubble problem, central banks would need to both mop up the excess liquidity sloshing around in the financial system and redirect their monetary policy strategies. But, with the world economy still in a fragile state, at least partly due to the hangover from the greatest of all asset bubbles, neither seems particularly likely anytime soon, in my view.
In this striking passage, he emphasizes the notion of “mal-investment” - a wasteful redirection of resources that occurs when market prices and interest rates are distorted by inflation:
In the mid-1990s, excess liquidity started to fuel a worldwide equity rally and also found its way into the Asian emerging markets, where it fed a massive waste of capital.
