The bubble century

[Don’t forget to check out the new Mercatus paper on housing and monetary policy during the Great Recession. (Written by Kevin Erdmann and me.) Also, I rarely change my mind on monetary policy, but today I did (at Econlog).]

Over the past decade, I’ve frequently argued that this will be the century of “bubbles”. I use scare quotes because bubbles don’t actually exist—i.e. they are not a useful concept. Rather this will be a century full of asset price movements wrongly seen as bubbles.

Here’s yesterday’s FT:

A collapse in real yields — the return that bond investors can expect once inflation is taken into account — is rippling through global financial markets and driving record rallies in assets from gold to technology stocks, investors say.

Let’s go back to July 2011, and see why I expected a “bubble” century:

But (seriously) are stocks now overvalued? Because I’m an efficient markets-type, the only answer I can give is no. So why does Robert Shiller say yes? Apparently because the P/E ratio is relatively high by historical standards. And he showed that for much of American history investors did better buying stocks when P/Es were low than when P/E ratios were high. Of course hindsight is 20-20.

I’d rather not get into the minutia of all the various ways of calculating P/E ratios. And I have no idea where stocks are going from here. Instead I’d like to focus on three arguments for relatively high P/E ratios in the 21st century American economy (however you’d like to measure them):

1. Stocks have done very well since the 1920s, which suggests that 20th century P/E ratios were usually too low.

2. American companies are making lots of money in the worst recession since the Great Depression. This is partly because US multinationals are making huge profits in the developing world. And this suggests that traditional market indicators based on the ratio of US corporate profits to US GDP may be outdated. US GDP is no longer the relevant denominator. So “E” may be relatively high for the foreseeable future.

3. My most important argument is that low real interest rates might be the “new normal.” The most striking characteristic of the US economy over the past decade is the unusually low level of both nominal and real interest rates. And it’s not just because of the current “unpleasantness;” rates also fell to very low levels in the early 2000s. Why have people missed this story? I believe it’s because they’ve assumed the low rates are some sort of Fed policy, not a free market outcome. But if the low rates since 2001 were an easy money policy, then why didn’t we see high rates of inflation and NGDP growth? So money hasn’t been easy, which we should have [been] obvious all along, given that INTEREST RATES ARE NOT THE PRICE OF MONEY, THEY ARE THE PRICE OF CREDIT. And these low real interest rates should support a higher P/E ratio.

I am a market monetarist because it provides the framework for making sense of what’s happening in the macroeconomy and the financial markets. If you thought that interest rates were being “artificially” depressed by the Fed back in 2011, then you’d naturally expect them to “bounce back to normal” at some point. Those people may be in for a long wait.

PS. Recall all those bubble articles written in 2002, when NASDAQ had fallen below 1200? Back when people laughed at all the fools who (in 2000) had believed that it made sense to invest in companies with no profits, like Amazon? Who’s laughing now?



24 Responses to “The bubble century”

  1. Gravatar of Spencer Hall Spencer Hall
    8. August 2020 at 10:54

    According to Alfred Marshall’s “cash balances” approach (“Money, Debt and Economic Activity” (2nd ed.; New York: Prentice-Hall 1953), p. 197

    “If the public considers its real balances excessive or deficient, forces will be set in motion which will alter the value of the cash holdings of the public, but not necessarily in the fashion desired by the public.

    For example, if the public on balance considers the real worth of its cash balances deficient, this will bring about an increase in the demand for money and a decrease in its supply.

    The velocity of money will decline, and if prices tend to be sticky, sales, production, implement and payroll will fall off. This will lead to reduced bank lending, a decline in the volume of money, and this will not be compensated by an appropriate decline in prices.

    Under these circumstances’ equilibrium is never reached, and the public in seeking to increase its real balances so reduces its effective purchasing power as to create a condition of chronic stagnation.”

    The demand for credit is a function of AD, money times transactions’ velocity. The decline in AD reduces bankable opportunities. So there becomes an excess of savings over investment outlets.

    An excess of savings over real investment outlets also exerts a contractive economic influence.

    As in Gresham’s law, a statement of the principle of substitution: “the bad money (IBDDs) drives out good (savings)”. The more valuable money is held (viz., income not spent), and the less valuable is used as a medium of exchange (aka: “shinplasters”).

    Asset price valuations are driven from the appraisal of loan collateral, which generally depend upon Gresham’s law: “a statement of the least cost “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most profitable (most widely viewed as promising). In other words, it’s dependent upon favorable capital gains taxation.

  2. Gravatar of Spencer Hall Spencer Hall
    8. August 2020 at 11:04

    Some people are blind. An increase in money products (commercial and Reserve bank credit), an increase in the supply of loan funds, reduces the real rate of interest, and has a negative economic multiplier. Go figure.

    Whereas the utilization of savings increases the real rate of interest, and has a positive economic multiplier.

    Whereas the 1966 Savings and Loan Credit Crisis (where the term credit crunch originated), was met by a decrease in Regulation Q ceilings for the commercial banks, the GFC was managed using the exact opposite prescription.

    As opposed to the .50% interest rate differential that was given to the thrifts by the 1966 Interest Rate Adjustment Act, during the GFC Bankrupt-u-Bernanke provided a preferential interest rate differential in favor of the commercial banks, i.e., the payment of interest on interbank demand deposits.

    Remunerating IBDDs induced nonbank disintermediation (where nonbank lending shrank by $6.2 trillion dollars, while the banks were unaffected, increasing by $3.6 trillion dollars).

    As Luca Pacioli, a Renaissance man, “The Father of Accounting and Bookkeeping” famously quipped: “debits on the left and credits on the right, don’t go to sleep with an imbalance”.

  3. Gravatar of xu xu
    8. August 2020 at 11:59

    Irrational Exuberance!
    When the market falls of a cliff, because countries contract everywhere, and nobody can pay their debts, you’ll be in for a rude awakening.
    I predict a very grim future for the USA.
    The currency will become nearly worthless in the next 20-30 years.
    The developing world is doing very well because there are lower barriers to entry. There is more freedom, and less regulation.
    It costs 50 cents to make a shirt, but you airheads in the USA buy it for $30, and sometimes even $40, which is laughable. You have zero negotiation skills with the supplier, because their economies of scale destroy any last vestige of interpersonal relationship (mom and pop stores). People have a severe lack of understanding: hence, the big profit margin. But that information asymmetry is starting to erode very quickly. And when it does, your companies will be bankrupt. Unemployment will be more than 50%, and the govt will be toppled and replaced with some dystopian totalitarianism run by degenerate drug addicts and dealers.
    History will write a book titled “idiot economists of the 20th and 21st century”. Let’s just hope your name isn’t in it

  4. Gravatar of Skeptical Skeptical
    8. August 2020 at 13:16

    xu has to be a joke.

    Unemployment will be more than 50%, and the govt will be toppled and replaced with some dystopian totalitarianism run by degenerate drug addicts and dealers.

    Where do i bet against this to make money ?

  5. Gravatar of Gene Frenkle Gene Frenkle
    8. August 2020 at 14:13

    Bubbles are malinvestment and sometimes in hindsight the malinvestment made sense and sometimes it didn’t. So the malinvestment from 2001-2008 was stupid but the malinvestment during the dot com boom was rational in light of how much Amazon stock is worth now…and the malinvestment to fuel the fracking boom made sense in light of how important cheap energy is to the American economy along with the global economy.

  6. Gravatar of Gene Frenkle Gene Frenkle
    8. August 2020 at 15:48

    sumner, I am reading your paper and I give you credit for continuing to focus on the 2001-2008 economy and its aftermath and with rejecting the conventional wisdom which is clearly wrong…sorry Republicans, Jimmy Carter didn’t cause the Great Recession. 😉

    So I am at the NZ, Australia, Canada part and the reason their respective housing markets recovered more quickly than America was because from 2001-2008 their economies weren’t dysfunctional because they were investing in increasing energy production. So in the face of higher energy prices one would think you would see investments in increasing energy production instead of a plateau in energy production as happened with American natural gas and global oil production. Those economies functioned properly and capital was directed at increasing energy production. So the Housing Bubble was the product of an an energy crisis that led to a dearth of quality investment opportunities and a dysfunctional economy.

  7. Gravatar of Gene Frenkle Gene Frenkle
    8. August 2020 at 16:27

    sumner, I am at the rent/hip cities part and I will add openly gay men returned to the city centers first and then some gen xers helped make cities more hip and then in 2000 millennials would have started going to college and living with roommates in hip cities. I remember talking with an older tech guy complaining about ten millennials living in a house in LA and driving up rents. So millennials also created a college enrollment boom along with taking on student loan debt to pay for college.

  8. Gravatar of Gene Frenkle Gene Frenkle
    8. August 2020 at 17:07

    sumner, the oil spike gets its first mention on page 42. Except Ford introduced a new Explorer in 2005 and sales declined…while Civic sales went up in the same period. Natural gas has not been mentioned yet and manufacturing jobs had a precipitous decline from 2001-2009 before magically beginning to rise in 2010…does Trump or fracking for natural gas get credit for more manufacturing jobs??

  9. Gravatar of Gene Frenkle Gene Frenkle
    8. August 2020 at 18:04

    sumner, I will add Texas has very high property taxes which discourages people buying residential investment property. Also the Texas economy was worse than the overall economy in 2002 so it was a little behind the curve.

  10. Gravatar of Art Andreassen Art Andreassen
    8. August 2020 at 18:54

    Scott: You say “money could not be easy because there was no inflation”. I deduce from that inflation is a result of too much money chasing too few goods, which increases the price of goods. Price inflation is measured by the Bureau of Labor Statistics by two different methods. The first compares the nominal market price of a good between two periods. The second has two steps. It takes the nominal price change for certain goods, then estimates a real dollar value of the quality change in those goods. This estimate of quality change is then added to the nominal price. In the second case the calculated inflation drops.

    The brings to mind Pigou’s anomaly of a rise in the price of bread leading to an increase in the demand for bread. Only this case is a mirror image, an increase in demand leads to a drop in price. Hasn’t this handling of the price of tech goods contributed to the low rate of inflation?

  11. Gravatar of ssumner ssumner
    8. August 2020 at 21:27

    Art, Even if the inflation data is off (and I agree there are problems), you’d get the same result using NGDP growth, which is not distorted by those measurement issues.

  12. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 03:19

    Your paper is pure trash. re: “At the time, this pattern was termed
    a “conundrum,” as it was assumed that boosts in shorter-term interest rates would also push up longer-term rates. In fact, longer-term rates were correctly signaling a long-run decline in the natural interest rate”. I couldn’t read it any further.

    You lack an adequate knowledge of money and central banking period.

    Greenspan never tightened monetary policy. And Bernanke never eased monetary policy. This is clearly demonstrated by monetary flows, volume times transactions’ velocity. The distributed lag effects of money flows are math constants.

    Long term rates fell because monetary policy was easy.

    What happened was that Bankrupt-u-Bernanke destroyed America.

    Bankrupt-u-Bernanke: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.”

    It was déjà vu. BuB contracted money flows (proxy for inflation) for 29 contiguous months (coinciding with the end of the housing bubble, and the peak in the Case-Shiller’s National Housing Index in the 2nd qtr. of 2006 @ 189.93).

    Then he bankrupt the thrifts by destroying their short-term funding. Bernanke should be in Federal prison.

  13. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 03:35

    There is no surer way to produce a recession than to shrink money flows. BuB’s contractionary money policy was the worst since the Great Depression where – money flows shrank between February 1930 thru April 1934.

    Bankrupt-u-Bernanke contracted (where the rate-of-change was negative (-), or less than zero, for this entire period), American Yale Professor Irving Fisher’s “price-level” for 29 contiguous months (from March 2006 until July 2008). This hadn’t happened since the Great Depression (from March 1930 until April 1934).

    I discovered the GOSPEL (which needs no disclaimer) in July 1979. If you can’t predict the markets, you don’t understand economics. Fundamentals precede the Technicals’.

    “As my good friend told me: Dr. Leland J. Pritchard, in his letter 9/8/81: “you may have a predictive device nobody has hit on yet”.

    I predicted the 4th qtr. 2008 GFC recession and the bottom in March 2009. I predicted both the flash crash in stocks on May 6, 2010 and the flash crash in bonds on October 15, 2014. I denigrated Nassim Nicholas Taleb’s “Black Swan” theory (unforeseeaable event), 6 months in advance and within one day.

    As I recently said:

    Economic prognostications are infallible. Equity turns not so much. But this year’s seasonal clock looks reliable. The downswing should snowball.
    Jan 22, 2020. 02:23 PMLink

    And I also called the bottom in 3 separate posts on March 23rd.

  14. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 03:56

    re: ” Consider the first rate cut of the 2001–2004 cycle, which occurred on January 3, 2001. Because the 50-basis-point cut was
    larger than expected, short-term interest rates declined on the news. However, long-term nominal interest rates rose sharply,”

    Greenspan never eased monetary policy until October 2002 (coinciding with the bottom in equities).

    It’s like what PAUL SPINDT described in his “Money is What Money Does”

    Although money has many close substitutes as a store of
    value, not even the nearest of near moneys shares with it
    the simple but momentous characteristic of routine exchange and circulation. [L. B. YEAGER 1968]

  15. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 04:06

    Some people prefer the “devil theory” of inflation: It’s all “Peak Oil’s fault”, ”Peak Debt’s fault”, or the result of the “Stockpiling of Strategic Raw Materials/Industrial Metals” & Soaring Agriculture Produce.

    These approaches ignore the fact that the evidence of inflation is represented by “actual” prices in the marketplace; The “administered” prices (oligopoly, monopsony, and monopoly elements) would not be the “asked” prices, were they not “validated” by M*Vt (money X’s transactions’ velocity), i.e., “validated” by the world’s Central Banks

  16. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 04:14

    re: ” long-term real interest rates appear to be declining over
    the long run, in part for demographic reasons.”

    Unlike the Gurley-Shaw thesis, there are stark differences between money and liquid assets. An increase in money products decreases the real rate of interest and has a negative economic multiplier.

    The utilization of savings produces higher and firmer real rates of interest and has a positive economic multiplier.

    If you believe as George Selgin does, that banks loan out deposits, then you’re lost, can’t see the forest through the trees.

    George Selgin (advisor to Congress): July 20, 2017

    “This is nonsense, Spencer. It amounts to saying that there is no such things as ‘financial intermediation,’ for what you claim never happens is precisely what that expression refers to.”

    Bank lending is inflationary. Non-bank lending is non-inflationary (other things equal).

  17. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 04:28

    re: “The lower interest rates triggered by today’s saving should be inducing an increase in investment”

    That conflicts with your N-gDp targeting thesis. It is not lower interest rates that are stimulating. When there is a widespread tendency for savings to become impounded in idle commercial bank balances or dissipated in financial investment (as opposed to targeted real investment outlets), AD falls.

    It is as Dr. Prichard said: “An increase in bank CDs adds nothing to GDP”.

    Not many people understand that banks create new money whenever they lend/invest with the nonbank public. And all monetary savings originate within the payment’s System (not outside it as Thornton said):

    Dr. Daniel Thornton is a former skilled FRB–STL economist, but he conflates stock with flow.

    Re my comment to Dr. Thornton: “Savings are not a source of “financing” for the commercial bankers”

    Dan Thornton reply:
    Thu 3/9/17, 2:47 PMYou
    See the graph below.

    Daniel L. Thornton
    D.L. Thornton Economics LLC

    My response back: “Never are the commercial banks intermediaries (conduits between savers and borrowers), in the savings-investment process.”

  18. Gravatar of Spencer Hall Spencer Hall
    9. August 2020 at 05:02

    re: “The second phase of the slump occurred between mid-2007 and mid-2008. NGDP growth (year over year) slowed to just under 3 percent in the second quarter of 2008 and to roughly 2 percent in the third quarter”

    That’s really insane. Why? Because monetary policy exerts its influence with a definitive lag effect. That’s why Paul Volcker created to back-to-back economic recessions.

    re: “and more than 100 percent of the slowdown in NGDP growth was due to the Fed sharply slowing the growth in the monetary base.

    That’s your problem. The monetary base has never been a base for the expansion of new money and credit. As the spurious base contains a currency component. An increase in the currency component is contractionary, not expansionary.

    re: “. In late 2008 and 2009, declining velocity was the problem, as the monetary base increased sharply”

    No, the problem was that the lag effect of money flows (lack of money, not velocity), fell off a cliff, registering their sharpest surgical decline since the Great Depression. This was already evident in December 2007, which didn’t hit until the 4th qtr. of 2008.

    re: “The Fed was under increasing pressure to tighten monetary policy in order to prevent inflation expectations from becoming unanchored.”

    People just don’t get FOMC schizophrenia: Do I stop because inflation is increasing? Or do I go because R-gDp is falling?).

    It’s the very reason N-gDp level targeting is “money illusion”. This was all explained by Dr. Leland James Pritchard in 1963. “The growth of time deposits shrinks aggregate demand and causes a reorientation of monetary policy towards greater ease or less restraint.”

    The longer the economic cycle, the more money that becomes impounded and the easier money policy, a by-product of which is a large dosage of new money, necessarily becomes as an offset. So all you’d have to do is go back and look at Dr. Philip George’s equation.

  19. Gravatar of Gene Frenkle Gene Frenkle
    9. August 2020 at 07:56

    sumner, excellent paper that convincingly puts the conventional wisdom to rest! You just need two charts that explain the underlying cause of the dysfunctional 2001-2008 economy—supply and price of global oil along with supply and price of American natural gas. So China’s boom led to a commodity super cycle but the most important commodity, oil, didn’t see an increase in production…and a very important commodity, natural gas, also didn’t see an increase in production in America.

  20. Gravatar of ssumner ssumner
    9. August 2020 at 09:51

    Thanks Gene.

  21. Gravatar of Gene Frenkle Gene Frenkle
    9. August 2020 at 11:35

    sumner, btw, home prices were out of control in February 2020 obviously on the West Coast and DC and Texas but also in the second tier hip cities of the Southeast like Nashville, Asheville, Charleston, and Raleigh to say nothing of Charlotte and Atlanta.

    That said, I have some anecdotal information about the 2001-2008 like young people racking up hundreds of thousands of student loan debt for professional degrees looking to take out a mortgage just to speculate on a condo because there was no chance they would end up living in that city. Plus I was around someone looking to buy in Henderson, NV just to speculate with no interest in living in Vegas metro. In 2009 I also had a nurse taking care of a family member that was stuck in an underwater house and so he didn’t believe he could move to go to get a nurse anesthetist degree even though that was always his goal…so he clearly should have been renting but someone convinced him to buy a house during in the 2001-2008 period.

  22. Gravatar of Kevin Erdmann Kevin Erdmann
    9. August 2020 at 11:54

    We may have erred in giving a false impression in the paper. We don’t deny that there was speculative activity. We just argue that it was one facet of a market that was largely reacting to fundamentals rather than uncontrollably moving away from them. High prices were systematically responding to rising rents. Higher rates of building were systematically responding to local demand for shelter.
    The central motivators for the peculiar housing market were migration flows and variance in rent inflation among metropolitan areas. The FCIC report spent one paragraph on rent to dismiss it as an important factor and it doesn’t have a single word on migration.
    One way I would put it is that there is very little we would challenge in the FCIC report. We would just suggest that the report that was published should have been an appendix to a report on how urban obstructions to housing had led to rising rents and a migration event.

  23. Gravatar of Gene Frenkle Gene Frenkle
    9. August 2020 at 12:59

    Kevin, thanks for your reply. My queries about the 2001-2008 economy are why were Fortune 500 companies passing up on cheap credit and the credit instead went to mortgages and student loans and Subways? Why did job growth and wage growth stagnate during that time period?? So I believe one needs a big picture explanation but your paper is consistent with my theory that the conventional wisdom is wrong. To me it’s pretty obvious the forces that undermined the 2001-2008 economy especially when I have quotes of Lee Raymond in 2007 saying America is about to become an importer of LNG…when there had been almost no progress in building LNG import infrastructure in America. Plus a consistent theme of articles about China during that period were how willing they were to poison and displace their citizens all in the name of cheap electricity and cheap transportation. So manufacturing jobs were going to China in part in search of reliable and cheap electricity…not simply cheap labor. So I posit the underlying issue with the Bush economy was we were in an energy crisis with no good solution to fix it…until the black swan event of fracking being proven economical in 2009. My theory also explains why Germany, Canada, Australia, and even NZ didn’t have a dysfunctional economies during the time period…while Spain and UK had housing bubbles just like America.

  24. Gravatar of Grant Grant
    9. August 2020 at 21:02

    The notion that bubbles don’t exist was falsified years ago by Vernon Smith, in repeated experiments.

    EMH is too simple to be applicable to real markets. In reality there is not just “public” and “private” information. Information is nigh-unlimited, but costly to gather and understand. Also, bulls are capable of bidding up a stock indefinitely, but bears are not capable of selling it to zero.

    Take a typical bubble stock, like Longfin in 2017. It was a crypto-scam: a complete fraud with no real operations. The index/ETF’s mistakes aside, people buying and holding LFIN probably did not know what an SEC filing was. To them a simple 10-Q was “private” information.

    When dumb bulls and smart bears clash, the bulls temporarily win. Bulls can keep buying indefinitely. As more shares end up in retail accounts, the supply of borrowable shares decreases, squeezing the shorts, forcing them to cover, and driving up the share price further. Eventually it all comes crashing down, for a variety of reasons, but a smart bull can make a lot of money riding a bubble.

    AAPL is now trading at a 34 P/E. Should lower interest rates have raised its multiple? Of course! But this much? I don’t think so, because the major threat to its NPV cash flows was not the discount rate as much as it was potential competition coupled with its lack of innovation.

    That’s 34 years of earnings. Look back at the disruption that’s occurred in the last 34 years, since 1986, and imagine what 2054 will be like. Is Apple at the forefront of many exciting, future technologies?

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