BEIJING (Caixin Online) — Japan and the United States are using asset bubbles to revive their economies. They are struggling to manage the speed of bubble expansion or contraction. This dancing on a pinhead brings big uncertainty to the global economy. When they fail, a global recession may follow.

As hot money chases the bubbles in Japan and the United States, the BRIC bubble has deflated halfway.

So far no big blowup has occurred, due to continuing loose monetary policy around the world. A soft landing is possible. But, the price is a prolonged slowdown. A major crisis would have prompted them to reform and then recover quickly.

Real economic reforms will occur only when bubble economics, in whatever form it appears, is thoroughly discredited. The first sign would be the replacement of the current generation of central bankers by a new one with a different ideology.

The tapering term

Tapering is new jargon that has popped up in financial markets to explain the ups and downs of the stock market. It describes the reduction in the Fed’s stimulus or quantity of monthly asset purchases.

In mathematics, it is the second order derivative of money supply. When the market gyrates on a second order derivative phenomenon, you know it is a really sensitive beast. In the financial world, a sensitive thing is usually a bubble.

“ Real economic reforms will occur only when bubble economics, in whatever form it appears, is thoroughly discredited. The first sign would be the replacement of the current generation of central bankers by a new one with a different ideology. ”

The U.S. stock market is in the early stages of a bubble. The market forecasts the 2013 earnings for S&P 500 SPX, -1.32% at $100 to $110.

The current market level gives it a price-earnings ratio of 15 to 16 times. Compared to the historical average of 15, it doesn’t look overvalued. But, three factors mean the valuation is stretched.

First, a declining interest rate could account for one-fifth of the earnings. The interest rate cycle has bottomed. Sooner or later it will go back up.

Second, the earnings may disappoint. The global economy is weak, growing half as fast as in the past. The diminished earnings prospect makes even the historically normal valuation expensive.

Third, the average valuation masks the bubbly atmosphere in most stocks. Energy, telecoms and financials are cheap due to reasons linked to their sector. The rest of the market has a very high valuation.

The odds are that the United States’ stock market is in the early stages of a bubble, say, 30% above a sustainable level. A bubble, after expanding gradually for a period, wants to surge and then burst.

In 1999 and early 2000, the U.S. stock market did that. It seems to really be in a euphoric mode now. Without an intervention, we could see a repeat of what occurred in 1999 and 2000. That would be bad news for the Fed. It would expose the futility of its bubble policy.

Tapering is something deliberately introduced to cool a stock market’s fires. The Fed wants to hold the bubble in animated suspension. Many have tried to control a bubble. None succeeded. Can Ben Bernanke pull it off? Maybe only for a short time.

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A bubble either expands or contracts. Holding steady is not a natural state. When the market declines significantly, say by 10%, you can bet that Bernanke would say that there is no end in sight for stimulus. The market would then throw away any caution and really party big. A repeat of 1999-2000 may be delayed for a month or two, but will happen eventually.

Japan’s bubble

Neologisms tend to accompany every bubble. Shinzo Abe’s “three arrows” is probably the lamest one for the launch of a bubble. Abe and his men are the same people who have kept Japan in stagnation for two decades. Can these people suddenly find some arrows to shoo away all the ills that have been festering for two decades?

The Abe government says it is copying the United States in stimulus. That is dangerous. Japan’s situation is much weaker than America’s was in 2008 and the country is not in a position to sustain a big bubble.

The publicly traded debt of the U.S. federal government was 44% of gross domestic product in 2008. It was low enough to sustain an uptrend for a few years, which was the foundation for another bubble. It rose to 74% last year, a worrying level, but not high enough to bring down the house.

The Japanese government stated that the outstanding amount of government bonds issued at the end of 2012 was 812 trillion yen ($8.12 trillion) USDJPY, -0.22% or 170% of GDP. Japan just doesn’t have a cushion to run a bubble.

Some analysts argue that Japan’s debt isn’t as high as it looks. While the gross debt is 230% of GDP, the net debt may be half as high. It is still too high to sustain another bubble.

Two-thirds of the bonds are held by private pension funds, insurance companies and banks. Japanese insurance companies mostly sell annuity products, like in China. Japanese households really have their retirement money in government bonds indirectly.

Because of its size and Japan’s low growth outlook due to a declining population, the stability of the Japanese Government Bond (JGB) market is fundamental to the country’s financial stability and its people’s retirement security.

Gov. Haruhiko Kuroda of the Bank of Japan (BOJ) recently said that the Japanese economy could handle interest rates 2 to 3 percentage points higher. But the extra interest burden on the government could be 6% of GDP. If the interest rate were to rise that much, Japan would likely experience a meltdown. Here is a guy who shouldn’t be where he is.

Abenomics cracks up

What Japan is doing now is like what some investment banks did in 2006, jumping into the mortgage market. Abenomics is just plain vanilla bubblenomics — ramping up the stock market and hoping for the best.

As Japan’s balance sheet is so much weaker than America’s was in 2008, Abenomics is unlikely to last another year. Some cracks are already emerging.

The JGB market has been in flux for the past week or so. The central bank has to buy whatever comes its way to stop the market from plunging. This exposes the weakest link in the Abenomics.

Promising 2% inflation isn’t consistent with the current bond yield. It requires the 10-year yield to rise above 3%. The Abe government needs to borrow 10% of GDP in new money in the current fiscal year, not counting the rollover amount for the stock. The threat to devaluate the bond market is a terrible idea.

This is why the Nikkei has been gyrating lately. Its recent doubling is just a fast bubble, pumped up by international hot money.

“ Gov. Haruhiko Kuroda of the Bank of Japan (BOJ) recently said that the Japanese economy could handle interest rates 2 to 3 percentage points higher. But the extra interest burden on the government could be 6% of GDP. If the interest rate were to rise that much, Japan would likely experience a meltdown. Here is a guy who shouldn’t be where he is. ”

Lately, Japanese retail investors have joined the fray, which encourages foreigners to double up. Japan’s market is grossly overvalued at present. It is well into bubble territory, much more so than the market in the United States.

Its recent volatility just shows to what extent sentiment is a factor in this market. Japan’s market reminds us of what happened to China’s A-share market in 2007. It doubled quickly in six months and then collapsed by 75% in the following year.

Japan’s top priority ought to be fiscal consolidation to reduce budget deficit. The previous government pursued this for several years. The Abe government has reversed the trend through its renewed emphasis on fiscal stimulus. It intends to borrow ¥48 trillion in the current fiscal year versus ¥43 trillion in tax revenue. No major economy has such a dire fiscal situation.

Threat to global stability

What the Fed and the BOJ are doing threaten the stability of the global economy. If their stock bubbles burst at the same time, the global economy is likely to fall into a recession. And it would be largely self-inflicted.

The U.S. economy has been recovering on micro strengths. Energy, agriculture, and high technology are some of the examples.

The United States’ labor market is flexible enough for many to accept lower pay in new jobs. Of course, many resist and remain unemployed. Some find it better to drop out of the labor force. Still, the market force is working to revive the U.S. economy through redistributing resources to productive areas.

The American economy would have recovered without the Fed’s quantitative easing. The latter just adds froth to the recovery. Now it has a stock bubble to reckon with. It doesn’t have the courage to accept a big drop in the market, but also fears a surge to be followed by a meltdown.

The Japanese government is still in a mood to egg on speculators. It probably doesn’t know what it is doing.

Japan has few experts in finance, which is a good thing and prevented its financial institutions from joining the Wall Street derivatives bubble. Japan’s financial system is relatively healthy due to this fluke. And the financial system has parked its money mostly in the government bond market.

What the Abe government is doing is threatening to bring down the government bond market, which would lead to a meltdown of the financial system.

Japan’s main problem is declining competitiveness, not weak demand. It doesn’t have an unemployment problem, i.e., no spare capacity. This isn’t the picture that prolonged deflation would conjure up. Its nominal GDP declined by 4% between 1994 and 2012. All of the decline can be explained by the adjustment during the Asian Financial Crisis between 97-99 and the 2008 Global Financial Crisis.

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Japan’s nominal GDP declined during these two periods by ¥48.4 trillion or 9.8% of 1994 GDP. Some businesses shut down or moved to lower-cost countries during the crises. And new ones didn’t emerge to replace them, which is a competitiveness issue. Japan’s deflation is really a sideshow, a symptom of what is happening to its industrial competitiveness.

Most economic problems take time to heal. Friction within an economy ensures that. Some economies are more flexible than others due to institutional or cultural reasons. Impatience for economic recovery through artificially pumping up demand impedes economic adjustment by diverting resources to stimulated activities like the stock or property markets.

As Japan blindly pursues its bubble policy, it could juice up the economy through the wealth effect, seemingly validating its policy effectiveness. Its consequences would be severe. A financial meltdown in Japan would surely send East Asia into a deep recession and probably be accompanied by competitive devaluation.

Activist central banking

The current generation of central bankers looks at an economy like mechanics at a machine, believing that they can fix a broken economy. An economy, of course, is not like a machine with exchangeable parts. And a central bank’s only tool is the creation of money and directing it in certain direction.

When an economy has complex problems, as most do nowadays, central banks playing with money isn’t a good solution. Its side effect — asset bubbles — makes things worse, creating a vicious spiral involving temporary recovery through bubbles, and then bursting and crashing.

Central bankers playing mechanics is a recent phenomenon. It began with Alan Greenspan in 1987.

Even though Greenspan is widely blamed for creating the Wall Street bubble that brought down the global economy in 2008, virtually all central bankers still talk like Greenspan. It is a generational phenomenon.

I suspect that, until the current central banking philosophy of improving economy by manipulating asset prices is totally discredited, the global economy will remain in flux. It has been five years since the Global Financial Crisis. It may take another five to get through the process.

Globalization led by multinational companies has fundamentally changed how an individual or global economy must behave. An economy has to behave more like a company to maximize internal efficiency. Otherwise, global arbitrage will expose one’s problems and trigger a crisis.

When a central bank creates money to stimulate an economy, it inflates asset prices first and non-tradables, like education, health care and housing, next. The economy becomes less competitive due to rising costs. It leads to currency devaluation. When everyone does it, competitive devaluation becomes a permanent phenomenon, making the global economy unstable.

The world needs a new generation of passive central bankers who would rely on market flexibility to repair an economy. Such people won’t be chosen now because governments love someone who promises quick results. Only when the current activist philosophy is discredited by another and bigger crisis can a new form of central banking come about.

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