The return of the bear

Figure 1: Asset Prices versus Consumer Prices since 1890

Far be it from me to underestimate the stock market's capacity to pluck the embers of delusion from the fire of reality. However, the crash in the past few days may be evidence that sanity is finally making a comeback. What many hoped was a new Bull Market was instead a classic Bear Market rally, fuelled by the market's capacity for self-delusion, accelerating private debt, and-thanks to QE2-an ample supply of government-created liquidity.

That Rally ended brutally in the last week. The S&P500 has fallen almost 250 points in a just two weeks, and is just a couple of per cent from a fully-fledged Bear Market.

Figure 2: "Buy & Hold" anyone?

The belief that the financial crisis was behind us, that growth had resumed, and that a new bull market was warranted, have finally wilted in the face of the reality that growth is tepid at best, and likely to give way to the dreaded "Double Dip". The "Great Recession"-which Kenneth Rogoff correctly noted should really be called the Second Great Contraction-is therefore still with us, and will not end until private debt levels are dramatically lower than today's 260 per cent of GDP (see Figure 4).

Figure 3: Growth peters out

With reality back in vogue, it's time to revisit some of the key insights of the one great economic realist of the last 50 years, Hyman Minsky. A good place to start is Figure 1 above, which shows the relationship between asset prices and consumer prices in America over the last 120 years.

One essential aspect of Minsky's Financial Instability Hypothesis was the argument that there are two price levels in capitalism: consumer prices, which are largely set by a markup on the costs of production, and asset prices, which are determined by expectations and leverage. Over the very long term, these two price levels have to converge, because ultimately the debt that finances asset purchases must be serviced by the sale of goods and services-you can't forever delay the Day of Reckoning by borrowing more money. But in the short term, a wedge can be driven between them by rising leverage.

Unfortunately, in modern capitalism, the short term can last a very long time. In America's case, this short term lasted 50 years, as debt rose from 43 per cent of GDP in 1945 to over 300 per cent in early 2009. The finance sector always has a proclivity to fund Ponzi Schemes, but since World War II this has been aided and abetted by a government and central bank nexus that sees rising asset prices as a good thing.