Bernanke’s Double Bubble Bind

In a speech to the American Economic Association on January 3, Ben Bernanke, chairman of the Federal Reserve System, took on the question of whether easy monetary policy led to the recent bubble in housing prices. I don’t disagree with his broad conclusions about the importance of regulatory policy. But it wasn’t until the end of his speech that he dabbled briefly with the far more important question: whether new types of monetary, fiscal, and regulatory actions are required to contain bubbles in all major assets, not just housing.

Constraining unreasonable inflation in asset prices, while still minding commodity prices and promoting growth, is a formidable goal. Formidable because dampening an asset bubble could constrain recovery. Formidable because inflows of foreign saving influence asset prices and can be difficult to control. Formidable because the growing power of hedge funds, banks, private equity managers, and others to take advantage of even tiny differences in returns across assets may be weakening central banks’ power.

As a student of economic history, Bernanke was well aware of the extraordinary tightening of credit during the Depression. And he reacted accordingly. But as someone who looks at the data, Bernanke also knows that each new economic cycle is unique. A few years ago, economists thought economic cycles were growing less frequent and severe. But now? We don’t know. In the recent great recession, things got much worse. In the financial markets (whose collapse made this downturn so severe) we’ve also seen some unusual and disturbing trends, including two asset valuation bubbles-each way out of line with the post-World War II pattern, and each followed by a recession.

The figure below depicts those bubbles. It shows the net worth of U.S. households as a percentage of their disposable income. Throughout the postwar period until the late 1990s, the ratio averaged about 500 percent-less if you exclude the bubbles. For every $1,000 of income, households in aggregate had net worth valued at about $5,000.

chart, described in previous paragraph

Increases in stock market valuations, largely for tech stocks, caused the first great financial bubble, which burst in 2000. Rises in housing and stock and other real estate values-an unusual combination-drove the second great bubble, peaking just recently. Typically, when one market experienced unusual growth relative to income (as housing did in the 1970s), others experienced atypical relative declines (think stock in the 1970s).

Despite a huge overall decline in net worth, by the end of 2009 we had already recovered to about the average level for the post-World War II period. Further significant spurts in asset values could easily move us back well into the above-average range. At this point, further steep asset gains may not be desirable. A wiser hope is for incomes to rise at above-average levels to make up for lost ground, with net worth rising in tandem.

If net worth should shoot up too much, however, the Federal Reserve and the Treasury will start asking themselves whether they must act to prevent a third financial asset bubble. They could react by trying to tighten regulation-e.g., lower loan-to-value or higher capital requirements, although in many areas that requires legislation. They could respond by raising interest rates. They may already be responding in part by selling back to private markets some of the many assets acquired during the downturn. Or they might simply threaten to do something. I was present in 1996 when Alan Greenspan, then chairman of the Federal Reserve, asked in a speech whether “irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” Although he did not intend it, the stock market took a fleeting dive the next day.

The influx of foreign money makes choices more complex. Bernanke hints at this by noting that cross-country comparisons show that greater inflows of capital tended to produce higher housing price inflation. But he didn’t carry his analysis past the housing market, where these inflows help explain the broader asset bubble. If housing had been better regulated, would other U.S. assets simply have bubbled more? Greenspan also confessed in a recent book that he felt he had limited ability to offset the effects of the inflow of foreign saving. Recent efforts to jawbone the Chinese to let the value of their currency rise and to invest more in their own economy represent one not-yet-fully-successful response.

Next we get to the hedge funds, banks, and private equity managers of money. As long as both foreign governments and the U.S. Federal Reserve try to keep interest rates or the value of their currency low, private money managers can effectively borrow at subsidized rates, or invest in undervalued currencies, while buying assets with higher expected rates of return and selling (relatively) overvalued currencies. (Another caution: this is almost all short-term financial investment, not real investment aimed at improving output or long-term productivity.) Without going into details here that are part of a longer story, this opportunism has sapped the Federal Reserve’s ability to spur increased real investment by subsidizing borrowing. In effect, many of the subsidies born of monetary and fiscal policy simply benefit those who can “arbitrage” or take advantage of the differential rates of return generated for existing assets.

I suppose that the U.S. (and world) economy could settle down to a new level of valuation of net worth relative to income: the two peaks seen in the graph, with net worth closer to 650 percent of income, could become a new norm. That could happen, for instance, if the U.S. and world economy became more stable, worldwide saving rates increased, and investments in total became less risky. But the two financial bubbles so far tell us a different story: worldwide government efforts to control economies, combined with the creation of large subsidized opportunities, have been inadequate to deal with, and perhaps even helped create, destabilizing arbitrage opportunities that are brought back into balance by a collapse.

My bottom-line bet: Bernanke’s double bubble bind tends toward trouble if triplicated.

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