World Bank Warning About New Bubble is Overblown

I can calculate the motions of the heavenly bodies, but not the madness of people. — Isaac Newton

In 1990, the Japanese real estate sector was valued at roughly four times the worth of the entire U.S. property market. Then, pop! Two decades later, the World Bank is warning of another financial bubble forming in East Asia that could splatter all over the global economy.

But these fears, while real, may be overblown. Not every upswing in business ends in red ink and tears. And although real estate, commodity and other asset prices are rising on one side of the world, a key ingredient is missing that’s present in all periods of speculative frenzy: Frenzy.

All bubbles are different, shaped by their own economic dynamics and historical features. All bubbles are also the same. They follow the same stages of development: mania, fast monetary expansion, price inflation, crash. Pick a financial craze  — coins of the Holy Roman Empire in the 1600s, U.S. railroads some three centuries later, dot-coms, baseball cards — that general pattern plays out no matter the object of desire.

Such episodes start with what economic historian Charles Kindelberger called a “manic phase,” during which wealthy people use their cash, and borrow, to invest in real or illiquid financial assets.

Yet there’s a difference, although often hard to perceive, between irrational exuberance and simple confidence that things are getting better. That blurry divide is what separates the common business cycle from, say, rabid speculation in Beanie Babies. For now, signs suggest we haven’t crossed that line.

To be sure, the World Bank does highlight some worrying symptoms. Money is gushing into East Asia like suds from a freshly tapped keg. This is “raising concerns about asset price bubbles . . . and prompting the authorities to rethink policies to address large and volatile investment flows,” the organization says in its report.

Other red flags include nonresidents of Indonesia gorging on the rupiah, which is driving up the currency and netting investors unusually fat returns. Share prices in the region also have risen an average of 60 percent this year. Companies such as China State Construction Engineering, the country’s largest home builder, are raising eye-popping amounts of money in IPOs. Real estate prices in Singapore shot up 16 percent in the third quarter (click on adjoining chart to expand). Credit, especially in China, is flowing like the Yangtze.

Yet such changes are partly a response to the slowdown in East Asia caused by the financial crisis, along with a return to longer term trends. Industrial production plunged across the region last year, while skittish foreign investors withdrew capital. A reversal of that process, even if it leads to some overheating, is normal. Asia, after all, is where the growth is. Says the World Bank:

“East Asia may receive a larger share of these inflows [of capital] because of a combination of investor expectations of stronger growth in the region than the rest of the world, the potential for currency appreciation and the growing liquidity and sophistication of the region’s financial markets.”

Regional financial authorities also are taking action to cool their economies. The surge in property prices spurred officials in Singapore to open more land for development and bar borrowers from deferring loan payments. And central bankers in East Asia are considering whether to limit the growth of bank credit, cap lending for real estate and ban loans for short-selling.

Parallel to the efforts of U.S. economic officials, East Asian countries that implemented stimulus measures during the financial meltdown are now thinking about how to take their economies off crutches. As in the States, these policies have at least two major goals. One is to stimulate domestic consumer spending, particularly important given the region’s heavy reliance on export-driven growth. The other is to give investors ample time and warning to prepare as governments gradually push their economies to stand on their own.

If that happens (a big “if,” granted), and as long as developed countries don’t tumble back into recession (big “if” No. 2), that process should begin to re-balance the disparities in investment returns, currency rates and other factors that in the short-term could produce another monstrous bubble.

Meanwhile, there are meaningful differences in the rate of economic growth in East Asia. Although bank credit is shooting up in China and Vietnam, it’s far more modest elsewhere in the region. Growth rates also vary considerably from country to country. Notes the World Bank: “Take China out of the equation. . . and the remainder of the region is set to expand at a slower pace than the Middle East and North Africa, South Asia, and only modestly faster than Sub-Saharan Africa.”

There’s danger, of course, in another thing bubbles have in common. In times of economic euphoria, risky financial decisions seem rational because everyone is, in fact, crazy as a loon. Or at least acting that way. Ten thousand shares of Pets.com? You bet! An adjustable rate mortgage with no money down? Might as well, since I’m flipping this dump anyway. The insidious thing here is that, at the time, such choices make perfect sense. Until sense is regained.

The main question is this: Are investors, government policy makers and other economic actors around the world, still dazed from the latest panic, already losing touch with reality? And is that condition sending the lemmings scurrying toward the precipice? Reality is a matter of opinion, of course, but the answer is probably “not yet.”

“This doesn’t feel like a bubble,” Hugh Simon, chief executive of Hamon Investment Group, tells the WSJ. “There’s too much skepticism” among investors.

Right. Still, stay away from the Beanie Babies.