Inflation is the only thing that can burst this bubble

The GameStop excitement seems to have abated for the moment. The markets and stocks that benefited from the Reddit frenzy – silver, and various heavily-shorted companies – have fallen back.

Meanwhile, intriguingly, wider markets appear to have taken that as their cue to start rising again. Which brings us back to the bigger picture question. When is all of this going to pop?

The hole in the deflationist logic

There is a lot of evidence of bubbles in markets right now. The GameStop hilarity is just one minor example. More classic indicators include IPOs (loads of them), M&A activity (picking up), esoteric things such as cash shells (SPACs) being mega-popular, prices being very high (US markets in particular, but most markets are now in "not cheap" territory). I could go on (in fact I have, here).

But what bursts this bubble? The reality is that most of the time, it happens in an environment where monetary policy is getting tighter, rather than slacker. That's not to say that it's triggered the instant that interest rates turn up. But bubbles don't tend to pop when monetary policy is still getting looser.

This brings us to the big dilemma today: a lot of the most bearish pundits in markets are hardened believers in deflation. They think there's nothing that can be done against the forces that beset us: debt (there's lots of it), demographics (older populations mean weaker growth), and disruption (technological advances are disinflationary). So at some point, we'll get another deflationary panic, asset prices will plunge, and that's why you should worry about a bear market.

I have a lot of time for a lot of these pundits. There's a lot of logic to their arguments. And it's perfectly possible that markets might once again look over the precipice into the deflationary chasm, freak out, and fall hard (although I have to say, that's no longer my "base-case" scenario). However, there's also a gaping hole in the logic here.

Deflation has been the big risk for decades now. And since 2009, it's been treated as an existential risk by central banks. During that period, what have markets done? That's right. They've gone up. If deflationary forces keep winning, as the bears argue, then all that happens is that the world's central banks will keep printing money. After all, there's no inflation – so why wouldn't they?

In that case, logically, you have to expect the same results – more asset price inflation. So instead, if you expect this bubble to pop at some point (and they do tend to pop, that's what makes them bubbles) you have to consider – what will make monetary policy tighten again in the future, at some point?

And the only answer to that is, inflation – not asset price inflation, but honest-to-goodness, more money in your pay packet (yay!), accompanied by higher prices in the shops (boo!), and a mixed-at-best reaction for overpriced assets.

Politicians will create inflation – and then the bubble will pop

So how do we get inflation? It's all about politics. After 2008, a majority of voters and politicians were panicked by debt. That led to a general embrace of austerity-type policies (though of course this was underpinned the entire time by hyperactive central banks).

But during the entire 12-year period since then, asset prices have boomed, while the “real” economy – and more importantly, wages – have remained pretty underwhelming by comparison. And politics has not stayed still. People have noticed this, and have been voting consistently for change, any time that they're given the option.

Again, note that this craving for change predates what is commonly dismissed as “populism”. In 2008, US voters ditched the Republicans for a fresh-faced “hope and change” candidate in the form of Barack Obama. In 2010, British voters elected the country's first coalition government since World War II.

Brexit and the election of Donald Trump in 2016 might have been the point at which this deep desire for a change of direction actually grabbed the headlines (in the UK, there was also the election of one Jeremy Corbyn as Labour leader in 2015, not to mention Bernie Sanders in the US). But the spark for it all was the financial crisis. Ever since that point, voters have been looking for a new direction.

Put simply, whether they realise it or not, they're fed up with a world in which politicians delegate responsibility for economic management to central bankers, who in turn have no real ability to do anything other than flood the system with loose money, which then washes up virtually everywhere – except into wage packets. That's what voters have been rebelling against this entire time.

Now, the pandemic could represent a turning point. For one thing, the trauma of lockdown coincided with the Brexit saga drawing to a close, and the end of the Trump presidency. People might be inclined to favour a bit of political stability over the tension and volatility of recent years.

However, far more important is that the pandemic has triggered a shift in power. Central banks increasingly play second fiddle to governments. Monetary policy (raising and lowering interest rates) is giving way to fiscal policy (raising and lowering spending and taxation).

This is ultimately a good thing; technocracy erodes democracy. We need to be able to change things by voting, which means the people we vote for need to have some sort of responsibility for enacting policy changes rather than delegating it to central banks or passing the buck to supranational organisations.

But it's also a messy process (that's politics for you). Can governments be trusted with control of the printing presses? Probably not. Will they spark more inflation than anyone could ever want? It's a likely outcome, or certainly likely enough to want to insure yourself against.

Will the bubble burst before inflation becomes a problem? It seems highly unlikely. Does that mean GameStop and the like could be just the beginning? Maybe not the beginning - but we've probably not seen peak madness just yet.

What should you do? Stick to your plan. If you don't have a plan, get one. Watch the inflation data this year. Make sure you own a bit of gold. Have a watchlist so that when the dips come, you know what you actually want to buy, and at what price. And subscribe to MoneyWeek if you don't already (six free issues free here when you sign up).