What Happens When Rampant Asset Inflation Ends?

Yesterday I explained why Revealing the Real Rate of Inflation Would Crash the System. If asset inflation ceases, the net result would be the same: systemic collapse. Why is this so?

In effect, central banks and states have masked the devastating stagnation of real income by encouraging households to take on debt to augment declining income and by inflating assets via quantitative easing and lowering interest rates and bond yields to near-zero (or more recently, less than zero).

The “wealth” created by asset inflation generates a “wealth effect” in which credulous investors, pension fund managers, the financial media, etc. start believing the flood of new “wealth” is permanent and can be counted on to pay future incomes and claims.

Asset inflation is visible in stocks, bonds and real estate:

The sources of asset inflation are highly visible: soaring central bank balance sheets, credit expansion that far outpaces GDP growth and ZIRP (zero interest rate policy):

Destroying the return on cash with ZIRP and NIRP (negative interest rate policy) has forced capital to chase any asset that offers any hope of a positive yield. As asset inflation takes off, the capital gains attract more capital (never mind if yields are low–we’ll make a killing from capital gains as the asset inflates further) which creates a self-reinforcing feedback: the more assets inflate, the more attractive they become to capital seeking any kind of return.

In effect, gambling on additional future asset inflation is the only game in town.Institutional money managers are buying bonds that yield less than zero not because they’re pleased to lose money, but because they anticipate rates dropping further.

As bond yields decline, the value of existing bonds paying higher interest rises. As crazy as it sounds, buying a bond paying -0.01% will be a highly profitable trade if the yield on future bonds drops to -0.1%.

With the cost of borrowing less than zero once the loss of purchasing power (i.e. consumer price inflation) is factored in, it makes sense to borrow money to increase speculative asset purchases to leverage up any gains from future asset inflation.

Look at how margin borrowing and stock prices move in lockstep:

The question that few ask is: what happens to pension funds that need 7.5% annual returns to remain quasi-solvent when asset inflation turns into asset deflation, i.e. assets decline in value? Take a look at the S&P 500’s rise to the stratosphere and ponder the monumental losses that would accrue to any institution that thought asset inflation was a permanent feature of modern life:

There are only two ways to keep asset inflation alive: one is for central banks and states to buy up major chunks of all asset classes, i.e. hitting every higher bid regardless of the risks of such a strategy, and the second is to pay households to borrow money to chase future asset inflation, for example, paying households to buy a house with a mortgage:

The insanity of these two strategies is no hindrance to their implementation.The collapse of asset inflation will implode all the fiscal and financial promises based on ever-inflating assets and reveal the unsustainability of the status quo’s strategy of substituting debt and asset bubbles for stagnating real income.

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  • jadan

    Here’s what you do. First stop thinking about “asset inflation”. Stop worrying about investors. We don’t care about paper profits and the people who are chasing them. These people are not producers and they don’t consume enough to move GDP numbers. Ever hear of the National Emergency Employment Defense Act, Smith? The Kucinich bill, HR2990, back in 2011? It was designed to provide employment in a financializing economy that is destroying productive jobs. It is a national jobs stimulus bill and a banking reform bill that turns economic policy away from its current financialization direction. We need money to rebuild infrastructure. Millions of jobs there, many millions. “Emergency” is the key word. You’re just playing the violin while Rome is beginning to burn, Smith. You smell the smoke and the best you can do is yell “fire”. GW loves this doom porn. I’m getting sick of reading it. When things fall to pieces you can say: see I told you so! That’s fine. But wouldn’t it be better to say: here’s a solution!

    • Brockland A.T.

      Upvote aside, CHS needs to make a living too. Its tough out there and who knows; maybe some people may find it useful.

      Things are so bad in America collapse is the new normal, though. Doom porn loses its sting when its becomes the reality of enough people not be something just read about.

      If some jobless or near person can get by on investments, power to him or her.

      • jadan

        There is such a lack of imagination in economic thinking. Everybody wants to be an investor and ride on the train and smoke cigars. Our economy is planned and managed by people riding the gravy train and living on Easy Street. Get me a ticket, too! Everybody wants money for nothing. That’s the American Dream. Work a little while then retire and live on investments. That’s not working. Smith calls it “asset inflation”. Actually, it’s just stupidity. No need to graph it. If you don’t have a productive economy, you’ve got nothing to invest in. We need the NEED Act, we need to get the financiers out of the driver’s seat and run an economy in the public interest. This means ending the Fed and handing the money power to the people’s government. Smith doesn’t get that. He doesn’t like government. The cure for economic doom porn is some fresh and imaginative ways to make government a people’s government.

  • animalogic

    This not a bad article, whatever it’s limitations are. It sets out in plain language the central economic strategy of our elites: transfer trillions to the 1% via central bank QE and asset inflation, maintain ZIRP/NIRP, for the same reason, and quietly strangle the productive economy so as to suffocate wage increases, and thus price inflation. It’s a great plan ( in the short/medium term) for the 1%….and after all, who gives a Shit for the 99% ?