The height of foolishness

The only thing keeping Irish bond prices from collapsing is the assumption that Germany will eventually pay.

The young woman in a burka is clutching a Fendi handbag in one hand and an iPhone 5 in the other. She is surrounded by five friends, who are also in burkas. They are hovering at the entrance to a shoe shop in one of Abu Dhabi’s many large shopping centres. What has caught their eyes is a pair of shoes by Salvatore Ferragamo.

Does the name Salvatore Ferragamo mean anything to you?

If not, he was an Italian shoemaker who understood that there had to be some design in between high heels and flat shoes and, borrowing from the ancient Greeks, came up with the enormously popular and original concept of wedges in the late 1930s.

Obviously the wedges make women (and some men) look taller than they are, without the feeling that they are on narrow stilts. I suppose, at the end of the day, the taller you are, the more attractive you feel. Height allows you to wear different clothes, and you will tend to look slimmer.

By driving a wedge between actual height and desired height, the shoe can improve your overall image, making the best of the material, making wearers feel better about themselves and looking better than would otherwise be the case – or than actually is the case.

As a result, Ferragamo’s wedges were (and still are) huge all over the world, and his basic designs have been copied and re-worked by other shoe designers down through the decades.

As I walked by the crowded shoe shop in Abu Dhabi last Wednesday, a large TV screen tuned into some 24-hour financial channels turned red as stocks across the world plummeted. Just then, the similarity between the wedges and the world’s central banks struck me.

The world’s central banks have been injecting money into the global economic system and, in so doing, driving a wedge between the actual performance of the world economy – which is weak and risky at best – and the observed performance of the world’s financial markets, which are behaving as if the world’s economy is strong, risk is minimal and everything is rosy.

By injecting so much liquidity into the financial system, the world’s central banks are helping to push asset prices way above what is justified by the faltering performance of the underlying economies.

This is obviously a very dangerous game because, like someone wearing wedges to attain a desired height, that person has to keep wearing wedges just to stay there. Similarly, the central banks, led by the Fed, have to keep injecting more and more liquidity simply to keep asset prices where they are.

All across the world, from the Gulf, to China, Europe and of course the US, asset prices have risen and risen, but the old economies in Europe and in the US have not recovered in any material way. In fact, European economies are now going into reverse.

The central banks also know that, quite apart from this wedge between the asset prices and the real economy, if there were to be a crash with investors selling because prices are too high and can’t be justified, the impact on the underlying economy of yet another financial meltdown would be atrocious.

Thus, they are in a monumental bind – they are damned if they do and damned if they don’t. They have to keep printing money to avoid a crash, but the more they print, there is a greater risk of that crash they are trying to avoid.

In the Gulf, everything is jaundiced by oil. The economies here are booming, and the fact that the Etihad flights from Dublin are almost always full is yet another signal of the disparity of opportunity between Ireland and certain other parts of the world.

All over this city, Irish accents can be heard, so much so that one lad approached me on the street about an hour ago – a fella I’d never seen before – and asked me what I thought of the performance of the Irish soccer team against Spain.
His story is like that of hundreds of thousands of Irish people, and millions of others in our developed economies. Since 2007, the economies of the west have not been able to hit the reset button. We are unable to emerge from the depths, and unemployment remains far, far too high.

All the while, the emerging economies of the world continue to catch up, and a bigger and bigger proportion of the world’s economic activity is migrating towards east Asia.

Technological changes are also undermining job opportunities in the west and, clearly, paying back ludicrously huge debts is sucking the life out of local demand.

Significantly, the country that appears to be worst affected – and whose predicament the west wants to avoid at all costs – is Japan. Not surprisingly, given Japan’s deflationary slump, money-printing by the Bank of Japan has been more aggressive than in any other country. The Japanese quantitative easing experiment is three times bigger than that of the US.

Because of the sheer size of the Bank of Japan’s money-printing initiative, it is in Japan – still the world’s pre-eminent manufacturer – where the monetary conundrum between asset prices and the real economy is most evident. The higher prices go, the more stretched valuations become, and the greater the risk of a sell-off.

Japan’s demographics have swung against the country and, without local demand, the implication is that Japan has to rob other people’s demand through exports spurred by a much weaker currency.

All this was too much for investors to take last week, and the Japanese financial markets took a hammering. This slump has spread contagiously around the world. People see that the Japanese authorities are in a sort of trap, and the question is whether what started in Japan will end in New York.

Risk has returned and, therefore, risky assets have been sold off. Such risky assets also include government bonds on Europe’s periphery, such as Irish government bonds, because there can be precious few other assets where the disparity between the expensive prices and the stagnant underlying economy is more stark.

The only thing keeping Irish bond prices from collapsing is the assumption that Germany will eventually pay – something the German constitutional court in Karlsruhe, not the Dáil, will decide.

But we’ve been here before. There have been rallies and setbacks in financial markets all the time over the past few years. That said, maybe this time it is different, because there is no escaping the fact that the central banks have driven a wedge between soaring asset prices and the anaemic economy underneath.

Can they do this indefinitely? Or are we, like a woman in Salvatore Ferragamo’s highest wedges, flattering to deceive; knowing full well that, at these ever-elevated heights, the risk of tottering over at a party just keeps on increasing?