Does the crisis protect us from creating another bubble?

bubblesLast month, President Obama warned that “[w]hen wealth concentrates at the very top, it can inflate unstable bubbles that threaten the economy.” On August 10, he further cautioned that even in a slow-growth environment, we have to avoid the creation of “artificial bubbles.”

These warnings come after a prolonged period of historically low interest rates and the Federal Reserve’s unprecedented Quantitative Easing (QE) program. Although recent talk of tapering has sent bond yields up, the program has seen the central bank increase its balance sheet from $900 billion before the collapse of Lehman Brothers to $3.6 trillion. The S&P 500 index is chasing new highs and is up over 240% since its lowest point during the crisis, despite slow growth in the economy. Even Ben Bernanke hinted that low interest rates may incentivize risk-taking by financial institutions.

In this environment, fears about new bubbles are widespread. Some claim that—following an unhealthy pattern of artificial recoveries since the tech-bubble of the 1990s—the driving forces of the current recovery are again real estate and automobile sales. As these are mostly debt-financed, the argument goes, the recovery is fuelled by cheap credit and far from being structural. It is true that house prices have seen an impressive recovery, rising 15% year-on-year in June. Similarly, one can find a very high correlation between car sales and economy-wide growth figures. However, correlation does not imply causation. After 5 years of deleveraging, job uncertainty, and a significant reduction in net household wealth, it seems likely that buyers would postpone important investment decisions. The recovery in housing and automobile markets is therefore also a consequence of increased consumer confidence that results from an improved economic outlook, something that can be seen as a positive sign.

Others see bubbles in gold, investment in China, in emerging markets generally (though this risk might have been reduced after important capital outflows following the Fed’s announcement of tapering), treasuries, college tuition, and exchange-traded funds (ETFs). Another interesting example is the so-called “carbon bubble,” according to which oil-exploring firms do not factor in the possibility of government action on climate change, which could see two-thirds of fossil fuel reserves remain buried. Most convincing, along with Ben Bernanke’s concerns, is the argument that looks at the structural impact of central bank policy on the economy: while large corporations have access to cheap credit that boosts their profits and sends their share prices up; small firms cannot obtain loans at all, and sorely needed investment is postponed.

But does the current rise in stock prices really indicate a growing bubble? After the 2008 crisis, everyone can tell the tale: it all started with the housing bubble that turned into the subprime-mortgage crisis as loans turned sour. Because the financial sector was then forced to curtail lending, the global economy was pushed into a recession, which turned into a sovereign debt crisis in Europe as tax revenues declined and exposed structural imbalances that had been hidden by the bubble.

In hindsight, this is an easy story to tell, but people know little about what creates bubbles in the first place, and—more importantly—what drives investors to make such seemingly irrational decisions when, ex post, it is so easy to identify a “bubble”. As Harold L. Vogel writes, financial asset bubbles are broadly seen as inflations of price beyond what would be expected based on fundamental economic features alone. However, it is very difficult to identify what prices these fundamental features give rise to.

Economic research has produced many theories about the emergence of bubbles but so far, no model has been found to describe—or even predict—patterns of financial bubbles. Among the most debated issues are the assumptions of efficient markets and the rationality of actors. Although it might be rational for single investors to participate in bubbles when they expect others to remain in the market, Vogel rightly points out that the very idea of a bubble requires that there is a wave of irrationality that carries a majority of investment decisions in the excitement of the moment.

Several explanations for this irrationality have been investigated, and behavioral economics will have much to contribute to the debate over the coming decades. At the heart of the creation of a bubble seems to lay a tendency of humans to linearly extrapolate from past performance. Neurological research suggests that investors even override more cautious instincts to sell at times when they fear markets might crash. Furthermore, dynamic prospect theory posits that people change their very attitude to risks over time. The more they have already gained, the less risk-averse they become—implying a strong departure from rationality.

Overall, academic research suggests that a (limited) departure from the investor rationality and efficient markets hypothesis is warranted. Under conventional assumptions, statistical theory would suggest that daily market return amplitudes of 4% would only be observed once every 63 years (but it has been observed on several days in 2008). Clearly, markets do not always behave rationally.

The question that naturally follows is whether this is necessarily bad. Some claim that bubbles might actually spur much-needed technological investment that can drive future growth. Furthermore, bubbles might just be part of the economic cycle of boom and bust. After all, household wealth took a $5 trillion hit with the implosion of stocks in the 1990s, without causing anything like the current crisis.

But this does not square with the common narrative of the post-2008 financial crisis. Paul Krugman has argued that what makes this time different is the concentration of risk in the financial sector. The reason the burst of the bubble caused so much damage to the economy was that banks had to repair their balance sheets and therefore curtailed lending, which caused the economy to contract and the governments to bail out banks in order to prevent further damage. More worryingly, these bail-outs came with few strings attached, so that banks have no incentives to avoid similar behavior in the future.

Is this what we are witnessing right now? By historical standards, price-to-earnings ratios are normal, but some analysts claim that these are unsustainable because profits are held artificially high by low borrowing costs. While the profit-to-GDP ratio has historically been at 6%, it is currently at 10%, and Smithers & Company, a London-based market-research firm estimates stocks are overvalued by forty to fifty per cent compared to historic values. Counterarguments cite lower taxes, globalization (profit-to-GDP ratios are inadequate as companies make much of their profit abroad), and high unemployment (that allows companies to cut payrolls) as reasons for the relative surge in profits.

It comes in the nature of a bubble that it is quite difficult to realize when one is in it. Prolonged periods of low interest rates and QE certainly bear the danger of providing excess liquidity to financial speculators. With sluggish growth, investors are sitting on large piles of cash and seek returns, which can prepare an irrational environment prone to the development of bubbles. Although the stock markets are high, the money supply remains low, and there does not seem to be the same sense of euphoria that we have seen during earlier bubbles. Furthermore, one has to remember that central bank policies often follow a Taylor rule of monetary policy, which is highly dependent on economic performance—low interest rates therefore indicate, above all, bad economic performance. For the moment, the danger of a financial bubble does not seem to be imminent, but both the President and the Chairman of the Federal Reserve are right to keep an eye on financial markets as the economy gathers pace.

Posted by: Marvin Gouraud

Sources: Harold L. Vogel (2010) “Financial Market Bubbles and Crashes”, Bloomberg, U.S. Census, Financial Times, Forbes, Wired, Huffington Post, The New York Times, The Guardian, The New Yorker, NBC News, Leir Center for Bubble Research, The Telegraph, CNN Money, The Economist, IMF, Federal Reserve,

Photo credit courtesy of Maricel Cruz (edited)

Royal Economics – or, why British taxpayers should celebrate the birth of a new prince…

Net Tax Revenue Royal Family

Whenever Buckingham Palace finds itself in the spotlight of global media attention, an ancient debate is revived, a debate that some experts estimate might be older than the monarchy itself: The debate of whether the royal family is still worth the taxpayers’ money in the 21st century.

At first, this might seem like a dispute that ought to be confined exclusively to British pubs, starring the Royals’ loyal supporters on one side and the isolated republican troublemaker on the other. Greatly diverging estimates of the costs attached to maintaining the Royal family can be exchanged  there, and then compared to the torrential flows of tourists who would have stayed at home were it not for the chance to catch the occasional glimpse of Queen Elizabeth II behind the windows of Buckingham Palace.

In these debates, the monarchists seem to have the edge over their subversive counterparts; for who could possibly argue that an average of GBP 42 million of Civil List payments (the Royal family’s annual income from the Treasury) in real terms over the past decade outweighs an added GBP 500 million in tourist spending on Royal castles, Royal towers, Royal mugs, and Royal mugs with Royal castles and Royal towers on them?

This squares well with 69% of British subjects agreeing that they would be worse off without the monarchy, against only 22% of unappreciative respondents in a 2012 survey by the Guardian. It is important to stress here that this argument is not based on the common misconception that the taxpayers receive about GBP 300 million from Royal assets every year. This income is generated by the Crown Estate, a collection of assets worth GBP 7.3 billion that has been surrendered to the Treasury by King George III as early as 1760 in return for a steady income through the Civil List.

Nevertheless, there is a case to be made to move the discussion out of the pubs and introduce economic reflection. So far, we have compared apples and oranges—government expenditure that has to be raised through tax revenue, and tourist spending, which needs to be taxed. This is like saying that it is reasonable for a simple employee to buy a GBP 40 million mansion because he just secured a GBP 500 million contract for his company.

Average Cost Royal Family

In order to answer the question, one has to make specific assumptions about how increased consumer spending will affect the economy. In traditional economic theory, an increase in demand for tourism represents an increased demand for exports. In a small open economy with flexible exchange rates and nearly perfect capital mobility, i.e. a country like the UK, an increase in export demand puts upward pressure on the interest rate, which draws in foreign capital. This increases demand for pound sterling on the foreign exchange market and therefore leads to an appreciation of the exchange rate until the pressure on the interest rate subsides. At this point, according to theory, the increased demand for tourism has been offset by a drop in exports (manufactured goods etc.) of the same magnitude. Overall, the output of the economy therefore remains unchanged.

Now what does this mean for tax revenue? Most tourist expenditures will be taxed at the VAT—so the tax revenue from increased spending on tourism is 20% of the increase in expenditure. At the same time, exports go down by an equal amount, but since exports are not usually taxed, tax revenue does not decline. While profits increase in the tourist sector, they decline in the export sector. Depending on gross profit margins in both sectors and the corporate tax rate, overall tax revenue therefore rises by slightly less than the VAT revenue due to increased tourist spending.

All of the following are assumptions within the framework laid out above and may be replaced by the reader in the attached Excel sheet.* The estimates have been chosen according to conservative estimates and available economic data. While most of the assumptions are self-explanatory, the fiscal multiplier can be used to assess the change in GDP due to an increase in domestic spending or an increase in export demand (both affect GDP and the exchange rate equivalently). In accordance with an econometric analysis by the IMF, it is here assumed to be zero—although an increase does not significantly change the results. Secondly, the VisitBritain estimate of the increase of consumer spending has been decreased by 30% because GBP 500 million in added tourist expenditure already include GBP 90 million in spending on admission to the Tower of London, Westminster Abbey, and the National Maritime Museum.

These figures include an estimated increase in consumer spending of GBP 413 million in 2011 due to the Royal Wedding, and an increase of GBP 243 million due to the Royal Baby. On the other hand, the wedding also increased security spending in 2011 by GBP 21.1 million. While this is a rough estimate, one also has to consider adverse incentives that reduce innovation and productivity increases in the export sector due to crowding out. Even without counting these long-term effects, it seems that the Royal Family is not worth the money.

Costs and Benefits

Obviously, these numbers will hardly impress staunch monarchists who have been supporting the Windsors for centuries—just like it will be difficult to convince die-hard republicans that the necessary inequality is acceptable as long as the Royals attract enough tourists. However, everyone can benefit from moving the argument beyond the exercise of shouting out the highest numbers in pubs. There is still cause for celebration: When everyone gets together and celebrates Royal weddings and babies, the monarchy heals Britain’s wounds of the financial crisis.

*Unless indicated as 2013 prices, the figures given refer to the respective year.

By: Marvin Gouraud

Sources: Centre for Retail Research, IMF, World Bank, The Economist, Yahoo Business, The Guardian, Slate, Intelligent Life, Reuters, Consultant-News, VisitBritain, The Telegraph,, European Commission, Office of National Statistics (UK)