Don’t fear the bubble

By Felix Salmon
May 22, 2013

Tyler Cowen has no truck with the Bubble Crew. He aligns himself with Paul Krugman and against Jesse Eisinger; we can add Gillian Tett to Eisinger’s side of the debate, and Jim Surowiecki to Cowen’s.

The bubblista side of the argument, at heart, says that the flood of money being poured into the global economy by the world’s central banks is driving up asset prices to well beyond fundamental valuations, and that if and when valuations revert to sanity, the unwind (the “burst”) could be disastrous in all manner of unpredictable ways.

This is a prediction which is very easy to make, not least because it has no time stamp associated with it. Tett, indeed, says that “these distorted conditions will remain in place far longer than most people expect”, which is little a bit weird: the whole reason why assets are expensive is precisely because, as Krugman says, “long-term rates are low because people, rightly, expect short-term rates to stay low for a long time.” And when long-term rates are low, that doesn’t just affect the price of long-dated bonds; it also drives up the price of stocks, which have infinite maturity.

Still, this is a good place to start, because there does seem to be consensus here: low interest rates, across the curve, are causing asset prices to rise, around the world. Is that prima facie evidence of a bubble? I’d say clearly not. The first job of financial markets is to be a place where you can convert future cashflows into a present-day lump sum, and that lump sum is naturally going to be higher when interest rates are low. Similarly, if and when interest rates start to rise, asset prices may well start to fall. But that’s just what financial markets do: they go up, and they go down. Not every rise is a bubble, and not ever fall is a bubble bursting.

The word “bubble”, at least for me, is a loaded term, with a specific meaning. For one thing, it implies speculation: people buying an asset which is going up in price, just because they think they’re going to be able to sell it to a greater fool at a substantial profit. The dot-com bubble was a prime example of that, with investors jumping onto high-flying technology stocks not because they thought the stocks were cheap but just because they thought the stocks were rising, and that they could make money day-trading these things. Much of the housing bubble looked like that too: you could buy a tract home in Phoenix with no money down, hold on to it for a few months, and then flip it for a substantial payday — even if you never expected to live in it. And certainly the bitcoin bubble fits the bill: pretty much the only reason to buy bitcoins and hold them for more than about 10 minutes is that you think they’re going to go up in value and that you’ll be able to make money as a result.

Is it possible to have a non-speculative bubble? In certain rare cases, perhaps. For instance, there was the market in Impressionist paintings in the 1980s: they went up in value enormously, and then the bubble burst and values came back down again. But people weren’t buying these things to flip them, and — importantly — no real harm was done to anybody when prices stopped going up and started going down. Similarly, in 2007, I said that if Manhattan property prices were in a bubble, then it wasn’t a speculative bubble. And again, whether you call it a bubble or not doesn’t really matter: when Manhattan property prices declined during the housing bust, no real harm was done to anybody.

In any case, the truly defining characteristic of a bubble is surely its bursting. The reason to be worried about bubbles has nothing to do with fear of what happens when everybody is happily making money. Rather, the problem with bubbles is that they burst; bursting bubbles are dangerous, unpredictable things which we should rightly be afraid of. Or, to put it another way: if asset prices simply decline without causing substantial collateral damage, then you weren’t in a bubble to begin with; you were simply in a bull market which then became a bear market.

Looking at the markets today, they show every indication of being bull markets rather than bubbles. For one thing, there’s not much speculation going on: no one’s day-trading junk bonds. Eisinger says that the One Percent are getting wealthier “through speculation”, and cites private-equity firms in the “house flipping” business, but that’s really not what’s going on at all: the One Percent are getting wealthier just because they own stocks and those stocks are going up, while the private-equity firms buying houses aren’t flipping them, but are rather renting them out, as part of their global search for yield. That’s real investment, it’s not speculation. What’s more, when Eisinger points to this chart as evidence that stocks are overvalued, he’s pointing to a chart which shows that — except for a deep “V” at the very height of the financial crisis — shows stocks trading at pretty much their lowest valuation of the past 20 years. Nasdaq 5,000 this is not.

More importantly, investors aren’t leveraged in the way they were during the housing boom: no one’s buying houses with no money down, and no one’s borrowing billions of dollars to invest in super-senior CDO tranches. The dot-com bust wiped out hundreds of billions of dollars of paper wealth, but only caused a relatively mild recession: the reason was partly the fact that Alan Greenspan was able to slash interest rates, but it was also in large part a function of the fact that very little of the dot-com bubble was fueled by leverage.

Today’s markets might well be frothy — but, in the short term at least, that’s a good thing for the real economy. So far this year, we’e seen 1,413 companies issuing stock onto either the primary or secondary markets, raising $288 billion in the process — that’s up 33% from the same period last year. (And remember, the same period last year included the Facebook IPO.) Amazingly and wonderfully, that total includes $74 billion of issuance in Europe, up a whopping 44% from the same period in 2012. Companies don’t generally raise equity capital just to sit on the cash: they raise it so that they can invest the proceeds into their business, thereby creating jobs and economic growth.

Companies are raising equity capital right now because doing so is cheap for them: the higher that stock prices go, the more that we can expect this trend to continue. And that’s good for the economy. And, of course, investors are getting wealthier, which causes some nonzero wealth effect in terms of the amount of money they spend. So, what’s not to like, in terms of markets going up? If it means that the population gets richer and companies have more money to invest in their business, what’s the downside?

Over the long term, expensive stocks are bad for people who are trying to save for retirement: the more you pay for your investments, the lower your ultimate return is going to be. But that’s a relatively minor concern right now. The bubble-worriers have something else on their minds — something more moralistic. They see the rich getting a free lunch: central banks dropping money from helicopters, most of which is going directly into the pockets of the top 1%. That isn’t fair, and they are sure that there’s some kind of cosmic karma which means that wherever there’s a party, there’s bound to be a hangover.

The view that “we have to pay a price for past sins” is nearly always wrong, and in any event the only real sin being committed here is that the rich aren’t sharing their good fortune with everybody else. The stock market is a rising tide which is lifting only the luxury yachts; everybody else is underwater. That is genuinely deplorable. But it doesn’t mean that we’re in a bubble, and it doesn’t mean that if and when the tide goes out, the rest of us are going suffer massive injuries. There are always tail risks, of course: there are always unknown unknowns. But for the time being, the most likely scenario is that when asset prices start to fall, the main people to be hurt will be the ones owning the assets in question. In other words, the people who can best afford it. That’s not a bursting bubble: it’s just a common-or-garden bear market, of the type that all investors should be able to withstand.


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The expectation that markets will perform a punishment role is really an abdication of responsibility for people who want to impose that punishment. Here it’s bubble warriors hoping that the market will punish the 1% for their sins against morality by taking all of the benefits. Of course it happens on the other side too with austerians saying that people have to be punished by the markets through unemployment when in fact they are refusing to admit that it is their responsibility for cutting government funding that results in fired teachers. Either way it is supposed to be the market gods punishing people who deserve it rather than government taking responsibility for actually determining funding public sector jobs or taxing the 1% enough.

Posted by tuckerm | Report as abusive

One symptom of a bubble is that people feel called upon to make elaborate arguments as to why there isn’t a bubble.

Posted by ytwod3621 | Report as abusive

One symptom of a bubble is that people feel called upon to make elaborate arguments as to why there isn’t a bubble.

Posted by ytwod3621 | Report as abusive

Under what has historically been “normal” conditions, the flood of money being injected into economies by central banks would cause bubbles, or at least, inflation. But most economies are not in a normal state. The reason the central banks need to inject money is the same reason there won’t be a bubble (assuming the banks recognize when to stop) – too much money is being extracted from the economy and held out of circulation.

This is self-evident, for when economies are not growing while businesses are realizing (I can’t say earning) normal or larger than normal profits, it means the profits are not being recycled back into the economy. If they were, the economy would be growing. The economy is a set and sequence of trades, and when it is flat, or growing slower than the population, it means there are less trades, and too much money is being taken out of circulation and put aside.

If central banks or governments don’t respond to this hoarding, then the economies will shrink, and possibly enter into a vicious downward spiral, as decreased confidence leads to decreased investment. To not spend or inject cash into the economy would be irresponsible.

This is not a good long term solution, as it eventually eliminates or at least minimizes market functions. Taken to an extreme, the central banks and government would essentially be the source of most individual income. The wealthy who are benefiting from the flood of cash don’t like the potential inflation, because they don’t like dilution of their assets. However, it’s just an invisible tax, which is basically driven by the narrowing distribution of income. The more that profits are directed to a smaller segment of society, the more that the larger segment demands a government reaction, which comes in the form of increased spending and cash infusions.

The need for the artificial support for the economy can be eliminated by forcing more of the profits to be put back into circulation. This can be accomplished by a few minor tweaks to the tax system:

1) Allow businesses to deduct dividends they pay from their taxable income, especially income earned overseas. This will put more of the profits back into circulation, as the caretakers of publicly owned corporations will have no excuse to hoard.

2) Increase the corporate tax rate, but offset that with generous credits for R&D, capital equipment, training, and health care – all expenditures that create economic activity and put money back into circulation. Between this change and the first one, there would be little reason to hold foreign profits outside the U.S. – they could easily be repatriated without penalty, while injecting those profits into the U.S. economy.

3) Tax individual interest and dividend income at the same rate as ordinary income, but allow it to be deferred when it is reinvested in new ventures. No reason why individuals can’t be allowed to grow the economy.

When a large enough share of profits are reinvested back into the economy, there is no need for injecting money into the economy, and less need for stimulus spending. If those who are earning big incomes are not putting enough of it back to work, the governments and central banks will have to continue to take their place.

Posted by KenG_CA | Report as abusive

@KenG_CA: excellent comment

Posted by SteveHamlin | Report as abusive

We could have a return to normality, but what could cause it? What would cause it, higher interest rates that is, would be greater investment demand driven by greater opportunities. While this will dampen demand for other assets and stop their price rise, rarely does it cause them to fall because although an income stream will be less valued, it will also be at less risk and the stream will liquidate the debt. A capital loss only occurs on the demand of a sale, while the income will steady. Greater opportunities will mean greater expected returns and greater value to other investments as well. Some, like tech, may subsequently bust, but we will still be better off from the investment, even if not as well off as we dreamed.

Posted by MyLord | Report as abusive


An alternate view: it feels like March, 2007 all over again:

“Subprime will be contained”  /testimony/bernanke20070328a.htm

Posted by crocodilechuck | Report as abusive

KenG, fantastic comment. The real problem is the extractive behavior of US corps. It is the driver of the long employment recession.

Posted by Dollared | Report as abusive

The people an top and the people on the bottom get hit hard in recessions. The people with the bad assets get it first, followed by bossiness owners who cannot or will not cut back fast enough (fixed costs are fixed). The unskilled and those not needed to make sales at the present get the bulk of the layoffs. Those with secure jobs can prosper by buying discounted assets and also cut interest payments on any debt they have.

Posted by Samrch | Report as abusive

I am am an example of a person whose income did not drop. So I was able and did buy stock in firms that where still making money and where not in debt during this recession. I made out like a bandit. If I had real estate skills or lived in a state where the population could be expected increase, I could have made money in that.

People with secure incomes and people who manage to keep their jobs prosper in recessions. But not business with high fixed costs or people in jobs that can be cutback in recessions (like engineers, construction workers, temps, etc.).

Posted by Samrch | Report as abusive

The only people with secure incomes who do not prosper during recessions are the credit addicts and those who planed leverage their way to wealth. Their loans where called or the asserts behind the leverage became worthless.

Posted by Samrch | Report as abusive

The vary rich and the very poor are the ones with most variable incomes. But politicians who want cut back do not want hit middle. So say hit those two.

The time hit them is in good times not recessions.

Posted by Samrch | Report as abusive

Valuations are high, revenue growth is stalling, and cost-cutting will only take you so far. I don’t know if it is a “bubble”, but it is definitely on the frothy side. A pullback at some point would be healthy.

Disclosure: still have 75% of investment assets in stocks, so I can’t be THAT concerned.

Posted by TFF | Report as abusive

What strikes me amount the market is three things:

1) They there has been no significant pullback in the four years since the market bottomed in Spring 1999.

2) The market seems to be completely oblivious of what is happening in the real world. The Chinese economy is slowly, the Euro is on the verge of collapse, half the Middle East is up in flames, and yet the market keeps chugging upward as if nothing is happening.

3) US unemployment is still above 7.5%

Now it may be that corporate earnings have become completely disconnected from the real world, but it’s not a bet I want to make.

Posted by mfw13 | Report as abusive

SteveHamlin, Dollared: thanks. Uh, would either of you happen to be a member of Congress?

TFF, mfw13, yes, a pullback would seem normal, but where will people put the money they get from leaving the stock market? That question fortunately kept me from selling off shares earlier this year. Interest rates are virtually zero, bonds pay so little they can only lose value, and I’m still wary of real estate.

Posted by KenG_CA | Report as abusive

@KenG, I’m looking at an expectation of zero three-year returns in the stock market, potentially horrible returns in the bond market, and ~1% returns on cash. Nothing is likely to do well (though rental real estate may be a good investment in some markets, if you care to put the time into the business), but cash isn’t any worse than the alternatives right now. It also offers the flexibility of jumping on a decline for a profit.

Posted by TFF17 | Report as abusive

@TFF17 – a couple ideas I’ll throw out there are:

REIT’s (or a REIT fund). They are yield plays, so there’s a risk if rates rise. At least rental income is tied to inflation, however – often directly (commercial or industrial property) or at least indirectly (residential) so if rates rise due to inflation there’s more protection than bonds. Commercial or industrial real estate income should also broadly increase if rates rise due a more robust economy (higher rents as leases expire and renew, and lower vacancy rates).

Floating rate fund – pretty much invest in leveraged loans, floating rate over LIBOR and reset every 3 -6 months. Credit play without the pricing downside than fixed rate bonds if rates rise. This asset class was hammered on a mark to market basis during ’08/’09, but it was the same phenomenon. Prices tanked, but defaults never got that bad, so anyone who held on through the downturn did OK. (Anyone who bought during the downturn made a tidy profit.) One downside is that these funds have relatively high expense ratios – I don’t think you’re going to find one with less than 1.5% to 2% annual expenses.

Just a couple ideas. I wouldn’t advocate dumping all other investments and piling into these rather narrow categories, but each is worth considering for a 10% to 20% asset allocation if you don’t feel great about other options.

Posted by realist50 | Report as abusive

Nice comment Ken_G!

Felix, surely it’s got more to do with behaviour and attitude to and perception of risk than it does to interest rates? People are currently falling over themselves to invest right now, and have been doing so in increasing numbers since September of last year. If you remember back to Mario Draghi’s comment about doing everythng necessary to protect the Euro, and that was when confidence returned to the market.

As share prices increased, consumers got more interested and started buying in increasing numbers. Share prices increased further. Despite the sceptics who for years have been berating the rest of us by forecasting nothing but doom and gloom, the Euro didn’t crash and burn, the US economy didn’t collapse under the weight of its rescue plan of QE stimulus, and even the Swiss Franc is now weakening against the USD, the GBP and the EUR as money moves away from safe havens and into areas of higher risk.

It doesn’t seem so long ago you were writing an article about the ever strengthening Swiss France before the Swiss National Bank protected it at a rate of Fr. 1.20 to the Euro; today it has weakened to Fr. 1.24 while yesterday it hit Fr. 1.27 for a time. The USD is now up from Fr. 0.92 to 0.96, and the GBP is up from a low point of Fr. 1.24 to a stronger Fr. 1.45 now.

Yes, there is profit taking, and I guess a lot of options are being cashed in too as they have suddenly become interesting again. As the executives pocket the proceeds of these freebies, they will begin to feel more expansionary in how they look at decisions and I am guessing will psychologically feel more inclined to take higher risks, dipping into their company cash piles and using the money for new projects to generate new profits and new growth.

Happy people invest more, spend more, and the economy benefits as a result. Anyhow, current stock market levels are only just thereabouts as high as they have been before, so how can that be a bubble? Yes, recent growth has been like that out of a recession, but I suspect it has a lot to do with suppressed demand and a wall of money hitting the markets needing a home to go to.

The optimists are returning and the pessimists have been shown up as scaremongers, often with selfish political not economic motivations for their words.

Posted by FifthDecade | Report as abusive

This year’s Golden Globe Award was voted the deadline in November 15th, before the World Cup qualifying play offs, which makes the C, not by virtue of its performance in the play offs Shen Yong, the competition become golden weight

Posted by traduceri romana daneza | Report as abusive