Reading the financial press you could be forgiven for thinking we are in the midst of a full blown economic recovery. Similarly, listening to the likes of Federal Reserve boss, Ben Bernanke, there appears to be more green shoots appearing in the battered global economy than one would find at a Griffith hydroponics setup.

More likely, what we are witnessing is the magic of a bubble, semi-popped, providing its makers with a few final glimpses of joy, before vanishing completely. As the results of the long-awaited “stress tests” of US banks are finally revealed in the United States tonight, the market continues to rebound significantly, with the S&P500 Index up 36% from its nadir, reached on 6 March 2009.

“Helicopter” Ben Bernanke (who once claimed that the best cure for deflation is to drop money from a helicopter) and who has undertaken the largest expansion of the Fed’s balance sheet in history, told reporters earlier this week that he expects “economic activity to bottom out, then to turn up later this year.” Bernanke did add his usual caveat, that “our forecast assumes continuing gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall.” In short, Bernanke noted that everything will be fine, as long as the thing that got us into the entire mess in the first place returns to its former self.

Asset bubbles are a wondrous thing. They are able to turn generally rational and often intelligent people into gullible fools. A powerful mob, coupled with a dash of greed are the two major ingredients in a bubble. However, a bubble’s real beauty lies in the fact that those inflating it are completely unaware of its existence. Investors in the South Sea Company truly believed a fortune could be made trading precious goods from South America and those who purchased shares on dotcoms really thought that the internet would revolutionise business. Now, deficit laden governments, highly leveraged companies and mortgaged-to-the hilt mums and dads who appear to believe increased spending is the solution to a worldwide economic collapse caused by too much debt.

Bill Bonner in the Daily Reckoning put it perfectly yesterday, explaining the psychology underlying the recent green-shoot led recovery:

People who had no idea there was anything wrong with the world financial system two years ago, now say the problem has been fixed.

Who fixed it? The people who had no idea what was wrong with it, of course.

What did they fix it with? The same thing that caused the problem they didn’t see — debt.

Who makes sure it won’t break again? The people who didn’t notice the wheels coming off the last time.

Unemployment in the United States, Europe and even Australia is edging up towards 10%, as it did in the Great Depression. House prices in the US have dropped for the past two and a half years, while property markets in the United Kingdom, Spain, Germany and Ireland have fallen off a cliff. While overall, residential property in Australia has remained remarkably solid, that has been due to timely government handouts, a resources boom and supply issues (high-end property, un-fettered by government handouts is down by upwards of 20%). Commercial property has started its descent and most pundits predict the fall will be steep and the landing rocky.

Despite all this, the lure of those green shoots has led to the Australian market jumping 25% in recent months.

It appears the bigger the bubble, the more people will believe it.

Peter Fray

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