Don’t fear the bubble

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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