The Federal Reserve, the Bank of England and the People’s Bank of China have this week all been faced with the same unpleasant reality: by their irresponsible monetary policies they have enabled gigantic asset bubbles that are redistributing wealth towards the criminal classes and in the long run will impoverish everybody else. Their reaction has been similar; to a large extent they have washed their hands of the problem.

The Bank of England’s response was most rational; it put up interest rates, though only by ¼%, far less than is required to right the foundering ship of Britain’s economy. The People’s Bank of China at least deplored the bubble, though it failed to recognize to what extent its irresponsible monetary policies and suppression of the yuan’s exchange rate had fueled it – but then after all, these people are nominally Communists; one cannot expect them to get it right every time when they are shown so many bad examples from abroad. The Fed on the other hand kept interest rates flat, as it has since last June, while easing its anti-inflationary language slightly – thus essentially acting as enabler to the Wall Street speculators, who had by Friday convinced themselves yet again that interest rates were about to drop.

All three countries have similar problems. In Britain, housing prices around London have soared far beyond the range of average or even affluent Britons. This isn’t just a question of monetary policy, which has been over-expansive but not excessively so. More important has been the increasing dichotomy between foreigners, who are not taxed on their “worldwide income” and Britons who are.

This has caused an enormous influx of wealthy rootless cosmopolitans to settle in London, where the great majority of their income is tax free, either because it involves one or other illicit activity abroad or because, in the financial services business, good lawyers can structure their clients’ activities and remuneration optimally. Since taxes on the average Briton have at the same time risen inexorably, as has government spending, the result has become a two-tier society, in which untaxed foreigners occupy the real estate that Britons who did not inherit it have no hope of owning.

There isn’t a good solution to this problem. Imposing British tax on foreigners, while unquestionably equitable and enabling some of the groaning burden on British taxpayers to be lifted, would almost certainly cause the financial business of the City of London to decamp elsewhere. The most probable destination would be Dublin, a master manipulator of its tax system, which is also facing a real estate meltdown and probable economic recession, and whose desire to gain business at the expense of Britain is second only to France’s.

Prior to the economically suicidal Financial Services Act of 1986, the financial services business was rooted to London by the British nationality of the major houses’ top management and shareholders. However in a world where the merchant banks have been liquidated, and the business is controlled from Frankfurt, New York or the Cayman Islands, there is no such attachment. Thus the Hobson’s choice now faced by any British government of whatever political color: the financial services businesses that appear to produce so much wealth will only remain in London if their mostly foreign managers are exempted from the taxes that normal Britons must pay. Such is the penalty for ill-considered legislation.

The problem is soluble only after a major financial crash, which will bankrupt many of the foreigners, devastate the London housing market and sharply reduce the importance and profitability of the financial services business. But that is not a fate to be wished on any country, however inevitable it may in the long run be.

China looks like the country with no problems; its last real recession was probably the hyperinflationary recession of 1948-49, as Mao Ze-dong consolidated power. The Chinese stock market is up 50% this year, after a rise of 130% last year, and is now selling on a P/E ratio of 45, while 1 million new brokerage accounts are being opened each week. Given that the Chinese banking system pays 2% on deposits at a time when true inflation is around 6%, and that it is still illegal for Chinese individuals to invest abroad, this exuberance is not surprising.

Certainly Zhou Xiao-chun, Governor of the People’s Bank of China can do no more than wring his hands. Any attempt to raise deposit rates to a more appropriate 6-7%, or lending rates up to a more appropriate 11-12%, would push the Chinese banking system into cataclysmic meltdown, since its bad debts almost certainly exceed $1 trillion. Even in China, that represents 40% of Gross Domestic Product, an amount that could with difficulty be financed but that would be hugely economically damaging until it had been safely funded with foreign debt.

There would appear to be very little hope of the Chinese middle class keeping their savings secure from a combination of a stock market crash and a banking system meltdown. Further, the uncovering of losses in Chinese state owned companies, and the new paradigm of resources at least for a few years being tight in China will cause huge unemployment at the state controlled behemoths that have been propped up by the banks, together with a major downturn in the Chinese urban real estate markets that have been so forth in the last few years. About the only consolation for the Chinese people will be that they will be joined in their losses by the half-witted foreigners who invested frenziedly in the Initial Public Offerings of the now-bankrupt Chinese banking sector. Misery, after all, likes company.

In the United States, the Fed’s initial decision last August to hold rates at 5¼% was plausible. The stock market had hiccupped in May and it could be argued that the U.S. economy needed time to catch up with rate increases already enacted and begin slowing inflation. However the stock market is up 15% since that initial decision and inflation is trending inexorably upwards, at 4% on the latest quarterly GDP deflator figure. Thus it has become clear that the current rate level has no inflation-suppressing effect. Meanwhile, in the financial markets confidence is not absent but grossly excessive, as fringe operator after fringe operator launches billion dollar buyout attempts.

Of the three economies, the United States probably has the grimmest next few years. Britain will do fine for those not involved in financial services or exposed to the London real estate market. China has cost advantages that are not going away, as more and more of its rural young migrate to the cities and enter the market economy. China’s downturn will be even more cushioned if the recent extension of private property rights to the rural poor proves effective, enabling the peasant masses to raise minimal capital and either start small businesses or re-deploy to the cities. In the long run, China will be a highly successful economy unless the government prevents it; the occurrence of a few financial crises and disasters along the way does not change this prospect.

For the United States, the reality is a darker one. Too much U.S. manufacturing capability has been redeployed to the Third World. Too much U.S. wealth has been squandered in speculation and overpriced real estate. Too much low quality immigration has taken place, undermining the living standards of the low-skill domestic workforce. An economic downturn will produce a Manichean struggle for the remaining resources, as occurred during the 1930s. In an era when protectionist sentiment is already rising, this is more than likely to produce a wrenching reorientation of U.S. society away from free trade and the free market and towards some kind of impoverished big-government socialism.

Thus burdened, U.S. business will find it very difficult indeed to climb out of recession and resume the process of improving living standards. U.S. commentators have since 1990 sneered at Japan, which found itself mired in stagnation for a decade and a half. However the future for the United States is likely to be more painful, as stock and real estate excesses must be worked off simultaneously at a time when the federal budget is under strain due to the retirement of the baby-boomers. This is however appropriate; it is the United States, through the Federal Reserve system that has since 1995 indulged in an orgy of irresponsible money creation that has fueled a decade of worldwide over-consumption. The Fed has been blamed for the onset of the Great Depression; that verdict is a little harsh but its responsibility for the unpleasantnesses ahead is unequivocal.

Finally, by referring in the first paragraph to the “criminal classes” I am not implying that these financial bubbles benefit only the Russian mafia; far from it. I am simply anticipating by a few years the verdicts of the US and EU judicial systems. In a world where former Enron Chief Executive Jeffrey Skilling gets a 25 year jail sentence, can anyone doubt that when the downturn finally comes a selection of currently highly regarded hedge fund managers, private equity find managers and investment bankers will find themselves facing several decades behind bars? They will be unlucky, just as was Skilling, that their particular organization suffered the spectacular bankruptcy that caused the random wheels of US or EU justice to grind into action. However the reality today, before the crash, is that there is no way of telling which of the moguls will be indicted and which will survive to endow major charitable foundations. Such is the lottery of a market bubble.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)