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, NewsDay.com

Photo credit courtesy of Maricel Cruz (edited)

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The politics of debt – why overcoming structural deficits might be both easier and more difficult than generally assumed

debt word collageOver the past few years, it seems that politicians have suffered an important loss of independence. Instead of displaying leadership and shaping economic policy, they are being chased by “the markets”. Central banks around the world have heeded politicians’ calls for help and reduced interest rates to historic lows. Nevertheless, growth remains slow, unemployment high, and investors nervous.

Not least in Europe, governments and the European Central Bank (ECB) outbid each other in their efforts to contain market fears and return the common currency to stability. It took no less than Mario Draghi’s announcement of the ECB’s “Outright Monetary Transactions Program”—the ECB’s commitment to buy unlimited government bonds on the secondary market—to break the vicious circle of spiraling government debt and bank rescues. Investor fears remain, however: Cyprus’ bailout in March this year warrants further caution on this front and when the Federal Reserve recently hinted at a possible end of Quantitative Easing next year, stock markets fell.

The reasoning underlying loose monetary policy in the current crisis is based on solid economic theory and most economists agree—at least in principle—that this approach is right. Similarly, all rescue measures following the initial Greek bailout certainly prevented a dangerous domino-effect. However, government bail-out packages in the Euro area, central bank bond-buying programs, and low interest rates share a common feature: they merely deal with problems in the short-term.

At first, this does not seem like a revolutionary statement—most economists will reply that monetary policy obviously only affects the short run and politicians will maintain that they are well aware of the need for structural reform. After all, long-term reforms require time to take effect; loose monetary policy, bailout and bond-buying programs are therefore dictated by current circumstances without leaving much room for alternatives. To a certain extent, this is true and in this sense, politicians and central bankers are merely reacting to the crisis. However, this story suffers from two oversimplifications.

First, it neglects the effect of short-term relief on politicians’ incentives to tackle long-term problems. Decision-makers have to strike a balance between the costs of reform and the costs of inactivity. On the one hand, implementing painful budget cuts and structural reforms that lower real wages and pension benefits creates discontent and therefore cost governments their popularity and votes. On the other hand, the immediate crisis results in political pressure that requires a reaction and the provision of solutions by politicians. By nudging central banks to loosen monetary policy and providing short-term relief in the form of rescue-packages, governments can avoid costly structural reforms while displaying activity and reducing popular pressure. The result is that—although economically sound—short-term relief might actually harm the process of necessary long-term structural reforms by reducing politicians’ incentives to implement it.

Second, the story ignores the immediate positive effects that the adoption of long-term reform measures can have. The reason why the Eurozone had to adopt several subsequent ultima ratio rescue packages is that the governments never provided a credible roadmap for sustainable reform of their public finances. Similarly, postponing decisions about the public pension reforms and other demographic challenges creates uncertainty in the business environment which severely reduces private investment.

The point here is that the way out of the current economic crisis lies in the adoption of both short-term and long-term measures. The rationale should be that a real solution is the adoption of structural reforms and the reduction of structural budget deficits. A simultaneous loosening of monetary policy together with emergency provisions for the stabilization of the financial sector are equally important, but they merely buy time for the former to take effect. While a tendency to myopic economic policy represents a systemic difficulty of any democratic system, more weight should therefore be placed on the benefits of reducing political window-dressing and increasing transparency and accountability in economic policy-making. If politicians stop blaming the markets for being suspicious of their policies, they can co-opt them and thereby regain control of the situation.

 

By: Marvin Gouraud

Sources: European Central Bank, Journal of Economic Policy Reform, The Economic Journal, Critical Review, The Wall Street Journal, Journal of Public Policy, Capital Markets Law Journal, Business Week, Council of the European Union, The International Spectator