Tight money causes bubbles

Of course I should have said “is associated with,” not “causes.”  But if you are trying to be provocative, why stop halfway?

I’d rather not talk about bubbles at all.  I find them boring, misleading, and I don’t “believe in them.”  (I don’t disbelieve in them either.)  But my commenters force me to continue talking about them.  So here is something designed to enrage everyone.

The Fed was created in 1913.  Let’s throw out the decades when there were World Wars, which (according to Krugman) were hopelessly distorted by rationing and price controls.  Here I will divide up decades into those with easy money (indicated by high and/or rising inflation) and tight money.

Easy money:  1960s, 1970s

Tight money: 1920s, 1930s, 1950s, 1980s, 1990s, 2000s.

Yes, I know the 1980s had more inflation than the 1960s.  But the rate trended sharply lower in the 1980s, and most economists think that is what really matters in terms of the real effects of inflation.

Now let’s look at bubbles of major significance.  This is subjective, but I will exclude bubbles that apply to individual stocks, commodities, or local real estate markets.  I want bubbles of macro significance.  I will also list the bubble peak, and whether there seems to be a rational explanation.  Note, according to some definitions of ‘bubble,’ if there is a rational explanation that is consistent with economic theory, it isn’t really a bubble.  But I am not interested in debating that issue here, I just want price spikes generally regarded as bubbles:

September 1929, stocks, fundamental explanation

Mid-1937, stocks and commodities, fundamental explanation

August 1987, stocks, deeply mysterious

April 2000, stocks, partly explicable, partly mysterious

Early 2006, housing, fairly mysterious (especially Vegas and Phoenix)

Early 2008, commercial real estate, fundamental explanation

Mid-2008, commodities, fundamental explanation

What do you notice about the pattern?  None of the 7 bubbles occurred in the easy money decades of the 1960s and the 1970s.  Why then this almost universal belief that easy money causes bubbles?

1.  People often misinterpret the stance of monetary policy.  As Milton Friedman observed, low interest rates are not easy money, they are a sign that money has been tight.  Tight money can depress rates in two ways, the Fisher effect and the income effect.  Thus tight money can lower inflation and real growth, and both of these effects tend to reduce nominal rates.

2.  People confuse easy money and easy credit.  Easy credit can co-exist with tight money.  Easy credit may contribute to bubbles (I don’t have an intelligent opinion on this question.)

3.  More sophisticated observers will point to real rates.  But not all bubbles are associated with low real rates.  The best example is 1937, when rates were very low because the economy was still very depressed.  Another example is the two 2008 peaks, when real rates had fallen due to weakness in the economy.  In other cases observers blame low real rates during the formative stages of the boom (say 1927, or 2003), not at the peak.

Do I really believe that tight money causes bubbles?  Given that I don’t believe in bubbles; that would be kind of silly.  But I do believe that “bubbles” are just as likely to form during decades when inflation is low, or falling, as during decades when inflation is high or rising.  It’s something to think about.

PS.  Many readers may find my views on bubbles confusing.  Last March I explained why I don’t think the debate over the EMH is very interesting.  The question isn’t whether the EMH is “true” or not (social scientists don’t even agree on what “true” means.)  Rather the question is whether the EMH or the anti-EMH position is more useful.  I have found the EMH to be very useful, but I haven’t seen any uses at all for the anti-EMH position.  That is what I mean when I say I don’t believe in bubbles.  I do not mean that I think Fama’s models can explain any and all market fluctuations.

PPS.  Austrian readers; please give me a few minutes to put my hands over my head and go cower in the corner before you respond.


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44 Responses to “Tight money causes bubbles”

  1. Gravatar of rob rob
    10. January 2010 at 09:26

    I do believe in bubbles, and I think it is simply a matter of herd mentality, not money. Consider all the studies recently about social networks. Supposedly people within a social network tend toward similar biases. Don’t Wall Street professionals form a social network?

    Or as Kafka put it: “Social circles are held together by a common insanity, but nobody within a particular circle knows what the particular insanity is.”

  2. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. January 2010 at 09:56

    I don’t have any hard empirical evidence on this subject but let me throw an idea out there. Could it be that the real problem is not the large relative price changes that result from “bubbles” but the debt that people acquire from leveraging them? And if during a period of tight money you have disinflation might that make bursting “bubbles” more problematic than during periods of loose money when you have accelerating inflation?

    There probably were large relative price changes or “bubbles” during the 1960s and 1970s. It’s just that their bursting had no grave consequences since accelerating inflation did not lead to debt deflation. Or am I just out in left field?

  3. Gravatar of Mike Sandifer Mike Sandifer
    10. January 2010 at 10:18

    While we’re at it, I think bubbles are caused by quantum foam, which was first postulated by Wheeler in the 50s, though not in association with financial bubbles. Interdisciplinary approaches are often best.

  4. Gravatar of Tom Dougherty Tom Dougherty
    10. January 2010 at 10:28

    Scott, I have two questions for you.

    1) Do you have any theory of how booms and bubbles are related? I think of a bubble as a manifestation of a boom, but not all booms lead to bubbles in the economy. Perhaps because of the changing structure of the US economy bubbles have become more common. As the US economy has moved from a manufacturing economy to a more service based economy excess money and credit of the boom has been showing up more in the consumer durable goods portion of the economy.

    2) Regarding the difference between money and credit, if there is an excess supply of money over the demand for money, won’t this excess money become available for leading and result in easy credit? In the loanable funds market an increase in the supply of credit will drive down the interest rates. And if the market rate is driven below the Wicksellian natural rate this will distort the structure of the economy leading to the bust in the real economy as emphasized by Tyler Cowen.

  5. Gravatar of rob rob
    10. January 2010 at 12:10

    I think we have bubbles for the same reason we have space-shuttle crashes. The more we think we have reduced our risk the more careless we become. There is no way out of this trap, because the less careless we are the more we reduce our risk leading us to eventually grow confident that we have reduced our risk and become careless again….

    I agree that there is currently a bubble in bubble theories. We won’t have another financial bubble until the bubble theory bubble bursts.

    As far as the “usefulness” of bubble theory. It is probably not useful for economists but very useful for investors. How can an investor decide how to allocate capital if they reason that everything is always fairly priced?

    If it had been easy to short the housing market, I suspect the first 100 names in the Boston phone book would have made better investment decisions than Wall Street insiders, who are more prone to group-think.

  6. Gravatar of Tom Dougherty Tom Dougherty
    10. January 2010 at 12:55

    Above I meant “…won’t this excess money become available for lending…”

  7. Gravatar of Jon Jon
    10. January 2010 at 13:46

    Scott + anyone trying to make sense of Scott:

    This subject is a linguistic nightmare. When someone asks whether you believe in bubbles, they are almost certainly challenging whether you believe that markets are efficient.

    There is a certain pernicious line of reasoning that the two ideas are causally linked. Yet they are not.

    In some sense, the focus on bubbles by mainstream public intellectuals reflects a betrayal of trust. For instance suppose you are asked whether you believe there was a housing bubble. If you answer yes, then the public has been taught to think that means you reject the notion that markets are efficient–after all certain public intellectuals have gone quite out of their way to link the one to the other.

    Whereas if you answer no, then the public believes you an even worst rube. Obviously looking back there was a bubble!

    But that’s just the rub.

    From the perspective of 2006, its really difficult to know whether housing prices are a bubble. After all, there is a rational reason to believe that a structural change has taken place: significant migration into the areas with the greatest price increases and changes in public policy.

    Remember in 2003, Chuck Rangel declared, “I do not want the same kind of focus on safety and soundness… I want to roll the dice a little bit more in this situation towards subsidized housing.” Then in efforts to reign in the GSEs were repeatedly rebuffed within Congress.

    Only in 2008 did it really emerge that this game was not sustainable. The GSEs were collapsing. Truth had been finally spoken to the lie: low-grade borrowers were not being wrongfully discriminated against the banking system had been rightfully discriminating against them after all until Congress demanded otherwise.

    Bubbles do not exist in the sense that at the time. Its not a bubble; its the rational summation of what people collectively believe to be most likely. After wards, we can see the bubble, but only because we know more now than we did before.

    That’s efficiency at work.

    Some people get hung-up by the height of the bubble. How can such large prices changes be rational? But of course they are–they just reflect the power of compound interest.

  8. Gravatar of Lorenzo from Oz Lorenzo from Oz
    10. January 2010 at 15:06

    Why do people worry about bubbles? Some of it is arguments over EMH, but people worried about bubbles before EMH.

    I would suggest that people worry about bubbles because of the concern that some set of asset prices may shift downwards suddenly. This concern arises because that does happen. Usually for assets which have shown dramatic upward shift in prices over some period of time.

    So, the question really becomes: why do we sometimes observe dramatic upward shifts in asset prices followed by sudden downward shifts? And how can we tell if such a downward shift is likely? And when?

    The only such phenomena I know anything about are in housing markets. Where constrictions in the supply of housing land clearly generate rising prices (particularly as the former are particularly likely in cities with high immigrant populations–as new market entrants then have particularly discounted political influence and such cities often have geographical positional goods which also encourage regulation to restrict land use–leading to rising demand with constricted supply hence rising prices). The rising prices lead to further interest in housing investment as an inflation-beating asset, which generates further investment in housing increasing demand further (with even further interest in keeping supply not able to respond fully to demand) and so it goes. Once an asset has an established record of prices rising faster than inflation, it obviously becomes a “good” investment.

    There is nothing in this that seems to me to cause any problems for EMH. People are reacting to the available information. If people could know when and if asset prices were going to shift downwards dramatically, that would be reflected in their actions and so in market prices. Hence the perfectly reasonable demand that people who “know” about bubbles tell us in advance if and when the bubble is going to burst.

    Where I start to diverge from “bubbles, what bubbles?” approach is the issue of the fragility of the asset prices. If part of what drives the rising prices is the experience of rising prices, then clearly a sudden loss of confidence that such will continue will mean a dramatic drop in prices of the asset. That issue of “fragility” seems to me a matter for reasonable concern. (For housing, there are other issues about inequality and effects on standard of living.) Not least because of the implications for the general health of the economy and the financial system.

    A lot of the point seems to me that we cannot know in advance the if-and-when prices collapse issue, because, if we could, prices would not rise so much in the first place. Ignorance is essential to such “bubbles” so the point about not knowing in advance is true, but does not disprove the reality of bubbles. On the contrary, that ignorance is essential to them happening.

  9. Gravatar of David Pearson David Pearson
    10. January 2010 at 15:44

    Scott,

    No need to resort to Austrian criticisms. Check your dates. You argue that the housing bubble occurred during a period of “tight money” — supposedly 20006. Sure you could say that. Or you could say the real estate market in southern California — the epicenter of the bubble — was over by then. In other words, its just as easy to argue that “tight money pricks bubbles”. Tight money during the 1920’s? I think there is an argument to be made that, despite the gold exchange standard (or because of it?), the U.S. had easy money during that period. Again, you may want to look not at when bubbles end (1929, 2006), but when they begin, how they progress, and why they end.

    Also, what was the 1950’s bubble? 1980’s? Its simply not useful to define a bubble as what happened to stocks in the latter period. Valuations went from extremely low levels in the early 80’s — following a decade-long bear market — and surged, yes, but bubble? Most analysts ascribe the ’87 crash to portfolio insurance, and the post-crash behavior of the market confirms the fact that the “crash” was just a sudden, large correction in a long, secular bull market. Maybe we didn’t know that before the fact, but we certainly know it now.

    So I think a little finer point to your analytical pencil is warranted.

  10. Gravatar of David Pearson David Pearson
    10. January 2010 at 15:58

    Almost forgot: 1930’s a period of tight money? The Fed tightened (I believe it was the end of 1937) when they raised reserve requirements, and the stock market fell. Again, the cyclical bull market in stocks that began in 1933 ended at that point. Are you saying bubbles are caused by tight money, or ended by tight money? The data you provide tends to support the latter hypothesis.

    I went back and re-read your post. You cite your bubble definition as “price spikes generally regarded as bubbles”. Of the examples you cite, I think the 1920’s and 2000’s late are “generally regarded” as such. The “nifty fifty” in the 60’s is said by some to have been a bubble, but that was just one portion of the market, and I think money certainly wasn’t tight by then (we are talking 1968 to 1973).

  11. Gravatar of Doc Merlin Doc Merlin
    10. January 2010 at 16:47

    1. I have to agree with David here, you are picking dates when the bubbles popped, not when the grew/started.

    2. You have a confusion of macro and micro here, ABCT uses the language of bubbles to describe macro effects caused by too easy money. It isn’t a theory of bubbles. Bubbles themselves are a micro phenomena. They only have macro significance when they get so big that they cause monetary or banking problems. A good example is the S&L crash or the Texas oil crash. Both were micro phenomena that had monetary/banking significance.

    Also, as one of your readers who believes in ABCT, I have to say I stated on your blog months ago that tight money could also have bubbles, because unlike for Austrian Business Cycles, you don’t need a wide spread easy money for a bubble, you only need easy money in that one sector/commodity/thing. If the widespread micro problems persist long enough or are large enough, then yes, the bubble can cause massive macro havoc, but fundamentally it is a micro problem. A good example of a bubble we have right now that will have very large significance is in “green energy.”

  12. Gravatar of David David
    10. January 2010 at 17:19

    Was 1929 a bubble? 1987? I thought those were “crashes.” It seems like you are including in your list some great declines and assuming a bubble preceeded them. Then, having found little evidence of said bubble you declare the concept “misleading.” (Or are you claiming these were “negative bubbles?”) I think you are including several events that are not bubbles, and by discarding anything regional or specific you are eliminating many events that could reveal characteristcs common to all bubbles.

  13. Gravatar of Joe Calhoun Joe Calhoun
    10. January 2010 at 19:50

    Why don’t commodities in the 70s qualify as a bubble by your definition?

    I don’t really believe in bubbles either. It does seem that there are times when investment in a sector gets overdone in the short run. When the investments are planned they make sense; the problem is timing. High commodity prices in the 70s produced excess investment in commodities production that caused a glut in the 80s and collapsed prices.

    Or was it that the dollar stopped falling and rallied big in the first half of the 80s? Hmmm, maybe monetary policy does play a role in these things? Did a rising dollar attract excessive investment to the US in the late 90s which played a role in inflating a tech bubble? Did a falling dollar in the 00s cause a shift in investment preference from stocks to hard assets? Maybe the problem is currency volatility? It seems to at least be a contributing factor.

    There can also be non monetary factors which affect investment. What about tax policy that favors one type of investment over others. Tax treatment of primary residence capital gains changed for the positive in the late 90s. Did that have an effect on investment in residential real estate? I’d be damn suprised if it didn’t.

    Bubble or not, I do think that government policy – monetary or otherwise – plays a big role in allocating capital in markets. If we get too much allocated to one sector in a short period of time, my first instinct to look for a government policy that caused it.

  14. Gravatar of stevend stevend
    10. January 2010 at 21:24

    I don’t think most people mind a bubble as long as the government is not asked to bail out the speculators.

    Bank depositers don’t want to bear risk. Why not lower their risk by sharply increasing bank capital requirements? There will be forgone interest for warehousing the money, but if depositers need higher investment returns they could buy stocks or bonds.

    Why are banks seen as the only place to get capital- if government backed bank deposits arent lent at low rates growth will grind to a halt?

    Wouldn’t it only cause the alternate sources of funding to become more attractive for investors? Bond yields and stock dividends would rise to lure money out of safer banks?
    The central bank could prevent a contraction in NGDP even with higher capital requirements by the banks, but most of the credit risk would be borne by bond and stock investors. If there is such a strong anti-regulation spirit today, isn’t this better?

    There was no strong drive for regulation after the tech bubble, because the stock holders knew the risks they were taking. Bank Deposits are a partially government insured illusion of safety that cause political problems when depositers lose money they thought was safe. Why is this illusion necessary for prosperity?

  15. Gravatar of mattmc mattmc
    10. January 2010 at 21:46

    The commentators have it vastly more right than the author. The easy money/tight money decades are nonsense. If anything, the problem is that the end of easy money causes crashes.

  16. Gravatar of scott sumner scott sumner
    11. January 2010 at 06:33

    rob, Maybe, but I’m not convinced. Shouldn’t contrarians make more money in that case? Why not start a contrarian fund on Wall Street?

    Mark, Some “bubbles” are followed by disinflation (1929, 1937. 2008) but those are the very bubbles that are explainable by fundamentals, hence not really bubbles. The true bubbles, the irrational price movements that have no fundamental explanation, are not followed by disinflation (1987, 2006).

    Mike. I would consider that a deep “root cause.” :)

    Tom,

    1. The sort of macro bubbles I discuss are more likely to occur during booms. But that is no surprise, both EMH and non-EMH models predict that. Don’t mix up money and credit, they are completely unrelated concepts.

    2. If there is an excess supply of money, and prices are sticky, then real interest rates may drop briefly. But that liquidity effect doesn’t last long, and doesn’t explain the bubbles I discuss. The reason investment is high during booms is not because real interest rates are low (they aren’t) but rather because people save and invest more when output is above average. People invest more for the simple reason that new factories are more likely to be built when existing ones are at capacity, and people save more when their current income is above their long run average income.

    rob, I just answered that at Wanderlust.

    Jon, I partly agree, but I don’t think it is quite so clearcut as you do. There are various ways of thinking about bubbles, and it isn’t clear which is the most useful. I try to explain what i think is the most useful, and take a non-dogmatic position. Notice that even though I believe in the EMH, I concede that I know of no rational explanation for the 1987 stock bubble, or the 2006 housing bubble in Vegas and Phoenix. If you say people believed this because of reason X, I agree, but the debate is over the question of whether experts could have known, ex ante, that reason X was wrong. By experts I mean investors and regulators. My hunch is that they couldn’t, but I am not sure why. The 1987 bubble might be easier to explain, because it isn’t clear we know how to ascertain the stock market’s fundamental value.

    Lorenzo from oz, I agree with much of what you say, but this puzzled me a bit:

    “That issue of “fragility” seems to me a matter for reasonable concern. (For housing, there are other issues about inequality and effects on standard of living.)”

    Recall that high housing prices do not result in fewer people being able to afford homes, unless they result in fewer homes existing. Homes are generally occupied, regardless of the price. I do agree with your next point about the broader economy, but that is best addressed through good monetary policy, not regulation.

    David Pearson, You said;

    “No need to resort to Austrian criticisms. Check your dates. You argue that the housing bubble occurred during a period of “tight money” “” supposedly 2006. Sure you could say that. Or you could say the real estate market in southern California “” the epicenter of the bubble “” was over by then. In other words, its just as easy to argue that “tight money pricks bubbles”. Tight money during the 1920’s? I think there is an argument to be made that, despite the gold exchange standard (or because of it?), the U.S. had easy money during that period. Again, you may want to look not at when bubbles end (1929, 2006), but when they begin, how they progress, and why they end.”

    You misunderstood my point. I wasn’t singling out those specific years as tight money, I argued they occurred in a decade of tight money. Yes, I understand that this is all relative, and in an absolute sense money wasn’t all that tight in any decade. My point was that in the two decades where it was (in relative terms) easiest, we had no macro bubbles. Surely that is at least “interesting” given the almost universal view that easy money causes bubbles.

    I’m stunned by your argument that 1987 wasn’t a bubble. If 1987 wasn’t a bubble THEN THERE HAVE BEEN NO BUBBLES IN ALL OF HUMAN HISTORY. That’s like saying 1929-33 wasn’t a depression. A bubble is generally viewed as a sharp rise and then fall in asset prices that can’t be explained by new information, or fundamentals. In 1987 stocks rose 40% then immediately fell 40%. There was no significant new information at all (unlike 1929 when stocks crashed because we were sliding into a depression.) I am mystified as to why you think bubbles exist, but 1987 wasn’t a bubble.

    More to come . . .

  17. Gravatar of StatsGuy StatsGuy
    11. January 2010 at 06:35

    OK, here is my post-modern submission:

    Part of the reason that we have such loud mouthed anti-Fed-intervention folks is because everyone is blaming the Fed for being wrong.

    One of the strongest arguments for an NGDP targeting regime would be letting the Fed step back and say the following:

    “Hey, it’s not US predicting lousy NGDP growth and price declines – it’s YOU, the market. And if YOU are SOOO confident that the market is wrong, then go ahead and make a bet. Put your money where your mouth is, and you’ll make a huge profit, and eventually when the market proves you correct it will self-regulate anyway.”

    Imagine all those talking heads on Yahoo Finance and CNBC and Bloomberg receiving that challenge. Imagine if positions in Trills that were > 200k were a matter of public disclosure after a 3 month lag?

    [As an aside, I’m warming up to the idea of a regime of 5 year Trills (based on nominal GDP) which could serve as the vehicle to target. Large enough to absorb a speculative attack, but not so large as to constitute too much of the Federal debt – there are good reasons to keep the average debt maturity in the ~7 year range. 20% of outstanding debt would be 2.5 trillion dollars, which is pretty hard for a hedge fund to manipulate, especially if all notes were traded in a central clearing house that was run by Treasury or a closely regulated exchange.]

  18. Gravatar of scott sumner scott sumner
    11. January 2010 at 06:59

    david#2, I am saying that bubbles are more likely to occur during decades where money is relatively tight, rather than decades where it is relatively easy (like the 1960s and 1970s) The nifty 50 were a minor issue, not a macro bubble that affected the entire market and economy. There were no generally accepted stock bubbles between 1937 and 1987.

    Doc Merlin, You said;

    “1. I have to agree with David here, you are picking dates when the bubbles popped, not when the grew/started.”

    That’s wrong. Read my post again. I am picking decades, not dates. The dates just identify the bubble peak. Every single bubble I mention gradually developed in a decade of relatively tight money.

    You said;

    “2. You have a confusion of macro and micro here, ABCT uses the language of bubbles to describe macro effects caused by too easy money. It isn’t a theory of bubbles.”

    My post isn’t about ABCT, it is about bubbles. Does ABCT predict that bubbles are more likely to occur in decades with easy money? If so, it is wrong.

    David#3, The sharp crashes in 1929 and 1987 were preceded by almost equally steep price runups. I included them because almost everyone who believes in bubbles includes them.

    Joe, You asked;

    “Why don’t commodities in the 70s qualify as a bubble by your definition?”

    That’s a good question.

    I am most familiar with two cases, neither of which fits the bubble definition. Oil soared from 3$ in 1972 to 10$ in 1973. But it stayed up there, and never got anywhere back down near $3. Furthermore the oil market was clearly impacted by a fundamental factor–increasing monopolization. So most economists don’t see it as a bubble. They don’t think speculative demand pushed up the price, rather an artificial cut in supply. During the 1980s prices fell gradually as conservation occurred. In 1986 there was a big drop due to a price war within OPEC. Again these are identifiable market factors, not irrational demand shifts affecting prices.

    Foods prices also soared in 1973 due to factors like weather, Russian demand, etc. Again, fundamentals explain the food market, so bubble theories were not popular when I was in college in the 1970s.

    I think the best case for a bubble is silver, and to a lesser extent gold. But I focused on macro bubbles, those not confined to small markets or individual stocks, but rather affecting commodities as a class.

    Of course there was a lot of inflation in the 1970s, and that put an upward trend on commodity prices.

    Otherwise I agree with much of what you say. I had forgotten about the 1985 dollar bubble, it also probably should have made my list. Nobody ever blamed that one on easy money, because the value of money itself was rising!

    stevend, All very good points. I agree. One small quibble–they did raise the capital requirements a few years back (Basel I and II standards). The purchases of MBSs by banks (wrongly labeled AAA bonds) was an end run around those regulations. But even there I agree with you. If we are going to have all this protection (FDIC and TBTF) then the government at least needs to try to protect its money through capital requirements, but it isn’t easy.

    mattmc, They misunderstood my argument. There was tight money even when the bubbles were developing. Read my responses to them.

  19. Gravatar of Doc Merlin Doc Merlin
    11. January 2010 at 07:44

    Also I forgot to say: How did the 2000’s have “tight money?” the fed’s rate was set below inflation for quite a bit of time. I can understand it being tight now, but I thought that the federal funds rate being below the inflation rate was a hallmark of lose monetary policy?

    Re: ABCT, I guess I misunderstood your reference to austrians as a dig on ABCT. 😉

  20. Gravatar of David N David N
    11. January 2010 at 07:48

    (I’ll be David N from now on to avoid confusion…)

    Scott, you said, “In 1987 stocks rose 40% then immediately fell 40%.”

    And then, they recovered their 1987 peak within 2 years and kept on going. In my view the aftermath of a bubble is that affected asset values in real dollar terms recover on timescales from decades to never. I think your definition of a bubble is way too broad. Bubbles are a disconnect of market valuation from reality. There’s been a handful of them in the past four centuries.

    I don’t remember 1987 well enough to say with certainty there was no “bubble justifying narrative” happening then, but I don’t think there was. I think if you took a poll of economists asking if 1987 was a bubble you might be surprised. If 1987 was a bubble, then we’re still in it.

  21. Gravatar of OGT OGT
    11. January 2010 at 08:02

    If tight money causes bubbles (or correlates to them), does that point to money illusion? I found this write up of a Min Fed paper on it using a heterogenuos investors model, I can’t say I found the write up persuasive, but it’s somewhat interesting.

    http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1135

  22. Gravatar of StatsGuy StatsGuy
    11. January 2010 at 08:46

    I once had a conversation with a Merryl trader, many years ago, who was heavily involved in 87. He said that afternoon, all of the execs were packing bags, many prepared to leave the country. Then they all got a call saying they had an unlimited credit line from the Fed.

    “So?” I naively asked.

    “It was a one way bet – we were bankrupt anyway. So if we win, we survive. If we lose, we’re no worse off. And with everyone making one way bets at the same time, there was no place to go but up.”

    I’ve thought about that a lot over the years. The reason we didn’t have a massive income-shock recession/depression (just a modest dip) could well have been because of that event. But of course, not everyone was making one way bets. Only those with nothing to lose and preferred access to credit were making that kind of bet. I wonder how much the Fed relied on that example in their intepretation of the events of September 2008.

  23. Gravatar of StatsGuy StatsGuy
    11. January 2010 at 08:46

    BTW, I should say wealth shock, not income shock. Very different.

  24. Gravatar of Tom Hickey Tom Hickey
    11. January 2010 at 09:26

    “Easy credit may contribute to bubbles (I don’t have an intelligent opinion on this question.)”

    Hyman Minsky and Irving Fisher had some interesting things to say about this. See Hyman Minsky’s financial instability hypothesis Fishers’s theory of debt deflation. Couple that with uncertainty (Keynes, Roubini, Taleb, and George Soros’s theory of reflexivity), and there’s ample reason to question REH and EMH in light of the current crisis.

    I did loose monetary policy create the crisis. Bill Mitchell argues against it in “Monetary Policy Was Not To Blame.”
    http://bilbo.economicoutlook.net/blog/?p=7003

  25. Gravatar of Tom Hickey Tom Hickey
    11. January 2010 at 09:30

    StatsGuy: “He said that afternoon, all of the execs were packing bags, many prepared to leave the country. Then they all got a call saying they had an unlimited credit line from the Fed.”

    Bill Gross now: “Follow the government.” The Fed opened the loan window, the market soared and is still soaring, and the dollar tanked, pushing money into the market. Same-o, same-o.

  26. Gravatar of Simon K Simon K
    11. January 2010 at 10:20

    Is it possible that during periods of relatively tight base money supply, banks see greater opportunities for higher risk lending (possibly partly because of the money illusion), and go out of their way to create bank credit as a partial substitute for money?

    Since bank credit tends to be sectoral (it has to be lent for some purpose or secured against something) that might encourage bubbles in specific sectors, depending on what looks like a good investment at the time. I realize this is more or less the opposite of what ABCT says :)

  27. Gravatar of Tom Dougherty Tom Dougherty
    11. January 2010 at 10:46

    Scott,

    You wrote, “If there is an excess supply of money, and prices are sticky, then real interest rates may drop briefly. But that liquidity effect doesn’t last long, and doesn’t explain the bubbles I discuss.”

    If the injection of an excess supply of money was a one time event then the liquidity effect would not last long, but the excess supply of money is not just a one time event but a continuous process. Also, because the excess supply of money is lent by the banking system this becomes an excess supply of credit and the effect on the economy becomes more than what happens to the rate of inflation or nominal interest rates. For one thing it impacts relative prices.

    You wrote, “The reason investment is high during booms is not because real interest rates are low (they aren’t) but rather because people save and invest more when output is above average.”

    I agree that the demand for loans increases during the boom and drives up the interest rates. But Federal Reserve engineered credit expansion drives the interest rates down below what it would have otherwise been (the Wicksellian natural rate) without the additional credit. So rates are high during the boom because of the increased demand, but would be even higher without the additional credit. Finally, the actual savings is less than investment with the difference between the two being an expansion of credit by the Fed. This, it is argued, affects the structure of production.

    By the way, I am amazed with the amount of writing you are able to do on this blog. Thanks for all your efforts.

  28. Gravatar of Joe Calhoun Joe Calhoun
    11. January 2010 at 15:00

    Scott, I do find it a bit humorous that you mention all those commodities rising in the 70s but find fundamantal explanations for most of them. Hmmm, how did that happen? How was it that all of a sudden fundamental factors forced almost all commodity prices higher all at the same time? That seems a mighty odd coincidence….maybe there was a common underlying factor?

  29. Gravatar of Tom Hickey Tom Hickey
    11. January 2010 at 15:37

    @ Joe Calhoun: “maybe there was a common underlying factor?”

    OIl shock. (This is all spelled out in posts at The Oil Drum.) US oil production had peaked in the early 70’s and was declining. This has changed the game since and will continue to do so as EROEI decreases. Moreover, the world is in the process of shifting from one primary energy source to spectrum of others, and the technology is still being developed. This is due not only to declining EROEI but also to the need to recognize externalities of fossil fuels and incorporate them so that nominal price matches true price, on the principle that what is underpriced is overused.

    In the meanwhile, petroleum remains the wild card. This is complicated by the coming online of emerging economies that are not energy-independent, increasing demand. The world is experiencing a respite at the moment owing to the present economic contraction, but as that winds down, demand will rise significantly, pushing petroleum prices up. Since petroleum-based energy figures into the cost of just about everything else that is produced or recovered, commodities included, expect prices to rise across the board. However, this does not constitute “inflation” technically speaking, since monetary inflation occurs when nominal AD exceeds real output capacity. Important to keep this straight.

  30. Gravatar of rob rob
    11. January 2010 at 17:03

    “Why not start a contrarian fund on Wall Street?”

    Good point. I was short the S&P in 2008 and made a 22% return for the year. And all I relied on for research was The Economist. Where are my investors? I’ll call it The Economist Fund.

    The current New Yorker interview with Fama mentions how he cancelled his subscription due to all the bubble talk. Maybe I”ll call it the Antifama fund.

  31. Gravatar of Joe Calhoun Joe Calhoun
    11. January 2010 at 18:26

    Thanks for the peak oil lecture Tom Hickey. I ain’t buying.

  32. Gravatar of Marcus Nunes Marcus Nunes
    11. January 2010 at 18:39

    This Philly Fed article “votes” on also monitoring credit.
    Apparently the Fed has to “look” at so many things that I find it difficult for it to be in any way “consistent”!
    “The figure shows that in response to higher expectations of
    future unemployment, stock prices
    decline and inflation declines. Flipping
    that around, we can say that when
    expectations for the future economy
    are unusually good, stock prices rise
    as does inflation. At least over the
    postwar period, the response of asset
    prices and inflation seems to line up
    better with the view in Bernanke and
    Gertler. Indeed, Figure 2 also shows
    that the Federal Reserve tended to
    tighten policy in booms and ease
    policy in bad times. That is not to say,
    though, that the Christiano, Motto,
    and Rostagno story is without merit.
    It is hard to argue against the view
    that monetary policymakers would
    be well served by monitoring credit
    market conditions as well as inflation
    in setting policy. Indeed, the Federal
    Reserve looks at a broad array of
    indicators when making decisions
    about the appropriate stance of
    monetary policy, even if low and stable
    inflation is a principal goal of policy”.
    Read the whole thing at:
    http://www.philadelphiafed.org/research-and-data/publications/business-review/2009/q4/brq409_future-and-economic-fluctuations.pdf

  33. Gravatar of Jon Jon
    12. January 2010 at 00:43

    Scott: isn’t the 1987 crash usually attributed to portfolio insurance.

    Paul Jones who made a lot of money during that incident, wrote: “There was a tremendous embedded derivatives accident waiting to happen in the crash of ’87 because there was something in the market that time called portfolio insurance that essentially meant that when stocks started to go down it was going to create more selling because the people who had written these derivatives would be forced to sell on every down-tick. So it was a situation where you knew that if you ever got to a point where the market started to go down that the selling would actually cascade instead of dry up because of the measure of these derivative instruments that had been written. And in the crash of ’87 you had an overvalued market and you also finally had a situation where every down-tick would create more selling and I think I understood the dynamics of that.”

  34. Gravatar of ssumner ssumner
    12. January 2010 at 13:07

    Statsguy, Yes, I like that “put your money where your mouth is” idea a lot.

    Doc Merlin, Low interest rates can be easy money, but when they persist they are more often an indication of a weak economy.

    David N, That’s a good point. 1987 was an example of market inefficiency, as either the pre-crash or post crash price had to be wrong. It was either a bubble, or a negative bubble. I should not have assumed that most economists assume it was a positive bubble. I was focusing too much on the EMH, which 1987 seems to violate. So you are right.

    OGT, It doesn’t so much violate money illusion as the EMH. I was being a bit sarcastic with the term “cause.” We all know how many people say easy money causes bubbles. I was responding, “OK, if there is causation here then why can’t I say tight money causes bubbles, after all the correlation seems better?” I should have made that sarcasm clearer (although I did mention it in the openning and closing sections.

    As far as “correlates”, I’d have to think about that. Just because a bubble is more likely to occur in a low inflation decade doesn’t make it easy to predict exactly when, and I also don’t know whether my sample is statistically significant. What I do know is that the alternative view (easy money causes bubbles) is even less statistically significant.

    Statsguy, You said;

    “I once had a conversation with a Merryl trader, many years ago, who was heavily involved in 87. He said that afternoon, all of the execs were packing bags, many prepared to leave the country. Then they all got a call saying they had an unlimited credit line from the Fed.

    “So?” I naively asked.

    “It was a one way bet – we were bankrupt anyway. So if we win, we survive. If we lose, we’re no worse off. And with everyone making one way bets at the same time, there was no place to go but up.”

    I’ve thought about that a lot over the years. The reason we didn’t have a massive income-shock recession/depression (just a modest dip) could well have been because of that event.”

    I pressume you mean after the market closed. I have to say that I am very skeptical of that theory for 3 reasons:

    1. The post crash performance of the stock market in 1987 adn 1929 were very similar (over the next 6 months.)

    2. The 1929 crash was a response to a severe recession that was already getting underway. There was no such downturn in September-November 1987.

    3. The Fed also stepped in aggressively in 1929, cutting rates and adding liquidity.

    Instead, the big problem was that after a few months the Fed went back to tight money in 1930, but not in 1988.

    BTW, there wasn’t even a “modest dip.” The 1987 crash which was almost identical to 1929 had zero cyclical impact. So much for the view that stock crashes depress AD. Monetary policy controls AD, and always has.

    Also, peopl’es emotional reaction in stressful situations (that the sky is falling) may be overreactions that go away after a few days pass.

    Tom Hickey, I have read lots of anti-EMH and anti-REH pieces, and I don’t find them persuasive. I have lots of posts on this topic.

    Tom hickey#2; You said:

    “Bill Gross now: “Follow the government.” The Fed opened the loan window, the market soared and is still soaring, and the dollar tanked, pushing money into the market. Same-o, same-o.”

    This is exactly the problem with anti-EMH theories, they have an explanation for everything. In fact, the dollar “tanked” well before the 1987 crash. Indeed many claimed the crash was caused by the dollar tanking. Now many claim the recent stock run-up was due to the dollar tanking. They can’t have it both ways.

    Simon K, I haven’t given that much thought, but I think people often tend to think about money and credit in the wrong way. The actual amount of base money in the banking system (in excess of what is immobilized by reserve requirments) is usually extremely low. People would be shocked at how low. So the money available for lending in either risky or safe loans doesn’t really come from base money, it comes from bank deposits. In aggregate the level of base money and reserves does constrain this (via the money multiplier) but my sense is that it isn’t the key factor. The ABCT may be wrong, but I’d be surprised if it was that wrong.

    Tom Dougherty, I won’t be able to do justice to your comment, but a brief observation.

    My view is that the direct effect of money as fuel for more lending is less important that the impact on AD through other channels. In other posts I talk about how, even apart from banking, more cash in peoples pocket will raise NGDP over time through the excess cash balance mechanism. This then feeds back and pushes up current asset prices through rational expectations.

    Your channel might apply as well, but remember that increases in the monetary base are often quite small. Of course the money multiplier means that M1 and M2 can rise considerably more, and perhaps this is what you have in mind.

    I will have to leave this as an open question, but it doesn’t really undercut my argument because increased lending doesn’t necessarily result in bubbles, it also depends on where the new lending goes. Banks can buy T-bonds, in which case they are lending to the government, and all you get is a bubble in the price of T-bonds (and which bubble proponents often ignore.)

    More to come . . .

  35. Gravatar of ssumner ssumner
    12. January 2010 at 13:25

    Joe, Two issues.

    There was a lot of inflation on the 1970s. A bubble is usually viewed as the rise in the relative value of an asset, not the nominal value. Part of the commodity run-up simply reflected inflation. That’s why oil never went back down to $3, whereas Vegas and Phoenix real estate has gone back down to the price of 6 or 7 years ago.

    And I still think that when people say bubble they mean speculative demand, so it doesn’t apply to OPEC or crop failures.

    There may have been bubbles in the metals that I overlooked. Where to draw the line is always a judgement call. But I don’t recall people perceiving things as bubbles (except silver and gold in 1980) and I am interested in macro-type bubbles that are generally perceived as bubbles (since there is no scientific definition.) If there were bubbles, they were less noticeable than the others I cite.

    Tom Hickey, Those are good arguments but:

    1. I don’t buy the peak oil view. But I do agree supply is fairly inelastic and rapid grwoth in 3rd world demand could push up prices sharply (as in 2008.)

    2. One important new trend is the huge rise in natural gas reserves due to new technologies. In the long run this will tend to restrain the rise in oil prices (I hope.)

    rob, Did you see the cover of The Economist this week? It says we are in another bubble. Should I sell everything and buy T-bonds?

    Thanks marcus. I will look at it.

    Jon, You may be right, but there is something ad hoc about a theory of something that has happened only once in 100 years. Why that day? The market (Dow at 2200) wasn’t all that overvalued, I’m not sure it was overvalued at all. It had been 2700 6 weeks earlier.

    Not saying you are wrong, it just seems a bit too ad hoc. I prefer to say we really don’t know.

  36. Gravatar of rob rob
    12. January 2010 at 15:43

    Scott, you said:

    “rob, Did you see the cover of The Economist this week? It says we are in another bubble. Should I sell everything and buy T-bonds?”

    No, just short stocks. No T-bonds.

  37. Gravatar of rob rob
    12. January 2010 at 21:41

    my big problem with the emh is how correctly it applies to the dating market. if a girl really likes me it only goes to show that she is a whore and really likes any guy that comes her way.

  38. Gravatar of Mark Caplan Mark Caplan
    13. January 2010 at 05:12

    If I understand it, our fearless blogger defines a “loose money” period as a time when the rate of change of the Consumer Price Index is high or rising. A “tight money” period is defined as a time when the CPI is low or falling.

    Here’s the problem: he is looking at consumer price inflation and not price inflation in general. Specifically, he is ignoring asset price inflation. In the 1920s, the price of stocks famously skyrocketed even though consumer prices held fairly steady. So there was rampant inflation — but in assets rather than consumer prices. By most measures, the decade of the 1920s was obviously a period of very loose money and rapid debt accumulation, owing to the conscious machinations of the Fed to drive down interest rates.

  39. Gravatar of scott sumner scott sumner
    13. January 2010 at 17:53

    rob, That reminds me about Groucho Marx’s line about not wanted to join any club that would let him in as a member.

    Mark, The term ‘inflation’ refers to increases in the price of goods and services, not paper assets. I know some Austrians would like to redefine it, but they haven’t succeeded. Most people still think 1974 was a year of double digit inflation, even though stock prices crashed. So I think of 1974 as easy money, despite the stock crash.

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  41. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. January 2010 at 14:39

    Recall that high housing prices do not result in fewer people being able to afford homes, unless they result in fewer homes existing. Homes are generally occupied, regardless of the price.
    Scott, you say what I said about inequality and living standards puzzled you. This puzzled me.

    Do you think that rising prices do not affect how many units are sold? What happened to supply and demand? Surely some people will be priced out of the home ownership market as prices rise. Particularly (for example) 8 or 9 times household median income for a median house.

    My point about living standards was shelter — including for rents which also rise (hence my point about inequality) — consumes more of income as prices rise.

  42. Gravatar of ssumner ssumner
    18. January 2010 at 13:24

    Lorenzo, Higher prices do not reduce consumption according to the laws of supply and demand. that is a misinterpretation of the laws. If the prices rise because of a increase in demand (as duing a housing bubble) both P and Q will rise at the same time. You move up and to the right along the supply curve.

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