Asset Bubbles: Does Talk Matter?
Now that economists have finally discovered that asset bubbles can be harmful (next week, they learn about the shape of the earth), we are getting a debate about how to deal with them. I'm sure that this debate can provide full-time work to hundreds of economists, but at the risk of sending some of my colleagues to the unemployment lines, let me suggest a simple solution: talk.
Economists seem to hold a bizarre view, that it is both very important that people like Fed chairs and Treasury secretaries be careful about what they say, but also that what they say does not really matter. While such contradictions are standard for the economics profession, I will argue that what these folks say can really matter.
Had Alan Greenspan been doing his job in the 90s, he would have been shooting at the stock bubble from around 1996 or 1997. I don't mean mumbling "irrational exuberance." I mean using his congressional testimonies and other public appearances to carefully detail how stock prices had gotten out of line with any plausible projections for future profit growth.
He should have presented the charts and tables showing that to give normal returns in the future, the price to earnings ratio would to rise to ever more absurd levels. Alternatively, we would have to believe that people were willing to hold stocks for returns that were equal to what they could get on government bonds. That did not seem to be the expectation of most people investing in the stock market in the late 90s.
In this decade, Greenspan should have explained that house prices had diverged from a 100-year long trend, and that there was no change in the fundamentals of supply and demand that could possibly explain this price surge. Furthermore, since there was almost no uptick in real rents, clearly nothing had changed in the fundamentals of the housing market.
If Greenspan had repeatedly made these points, and noted the practices of firms that were supporting the bubbles (naming specific firms, where appropriate), he could have placed considerable pressure on the big financial actors behind these bubble. It would not have been possible for the Robert Rubins of the financial world to say that "virtually nobody" saw this crash coming.
The financial industry executives responsible for bubble promotion would be forced to justify their policies at the time, and likely have to face personal lawsuits after the fact if they continued to pursue reckless policies after having been explicitly warned. Just following the herd would no longer be a safe course for the wizards of finance, as it is now.
The economists who missed the bubbles will all insist that this "bubble talk" policy from the Fed will not work. Of course there are other tools that can and should be employed. (Having regulators who are awake would be helpful.)
But what is the argument against bubble talk? What possible harm could Greenspan have caused if he made his bubble warnings and they were ignored? Did he have anything more important to talk about during the bubble years?
Economists seem to have learned at least one lesson from this debacle: bubbles are not cute. If economists can just get in the habit of being open to new thoughts, maybe they can also consider a broader range of tools to combat bubbles.
My memory is hazy on this but if I remember correctly the Greenspan under Clinton was not the Greenspan under Bush.
I seem to remember Greenspan being a deficit hawk, and someone with concern over the national debt and the interest we were paying on both the deficit and national debt. After the deficit was balanced and while Clinton was reducing the national debt to some extent, I never heard Greenspan push for tax cuts or express any concern over the budget surplus.
Enter Bush.
Not long after Bush took office I remember seeing on TV, Greenspan and Bush come out of an office where they had a meeting. Not long after seeing this I saw Greenspan testifying before a Congressional committee where he warned against the Government having too much of a surplus and backed the tax cuts Bush wanted. I beleive he also claimed that having a deficit or some national debt was somehow a good thing.
It was after this testimony from Greenspan where he seemed to do an about face on his prior beliefs on tax cuts, deficits and national debt, that I remembered his coming out of that office with Bush and believed that Greenspan made a deal in that office to go along with everything Bush wanted to do in order to keep his job as Fed Chairman.
As I said, my memory isn't what it used to be on some details, but coming out of that office together is still crystal clear.
December 19, 2008 9:46 AM | Reply | Permalink
Give John a cigar - you just explained Greenspan's about face.
December 19, 2008 11:08 AM | Reply | Permalink
I too remember the hearings, and how the minority Democrats kept pushing Greenspan to address, to speak out clearly the dangers.
At the time, it was a major and timely issue of debate, about Bush’s and Republicans starve the beast, Tax cutting plan.
The coward Greenspan, wanting to appease the new Republican Masters, would not give the citizens the ammunition, which would have created a bulwark against the ideology of trickle down/tax cuts for the rich.
Instead, the working class gets Greenspan speak; about how some deficit spending is good.
How good is deficit spending now coward?
The well healed not only took the cream off the top, they’ve depleted the whole supply, eating up all of the reserve.
The starved beast is dying and the beast was us.
December 19, 2008 12:20 PM | Reply | Permalink
I am not an economist and I do respect the energy and the economists here are putting into these issues. However, I think you all are going on with a fatal error in the design of your conversation. You are tending heavily to talk only as economists and strictly within the domain of the economy. Economics, however, is just one set of tools for public policy as the economy is just one tool for the common good. What you take into account as economists talking to economists about economic theory doesn't sufficiently take into account what the economy is for. Not only does public policy suffer, but so does economics. It's not designed to be a specialty unto itself. I understand you must shop talk, and appreciate the value of such talk enormously, but shouldn't that happen within clear frames of what the theory is for. In this society I should hope it is for deepening and furthering economic democracy, equity, the economic capacity for individuals to participate politically, etc. If all of this is being taken into account in your discussions, it certainly is not clear to an informed and educated non-economist like me.
respectfully,
michael johnson
December 19, 2008 10:47 AM | Reply | Permalink
May the Saints preserve us.
Did the same people say it in the same sentence like you did? Of course not. Sheesh.
What Greenspan had to say was carefully crafted to be as obscure as possible, BECAUSE it mattered.
If Greenspan had followed your prescription of talking down the market boom, I'd bet that you would be first on the bandwagon to lynch him for talking down prosperity. Clinton didn't sign a tax cut in '97 because everything was rosy.
Let's consider the bubble in Treasuries today. Is it a bubble or not? Why is Bernanke promising to make it larger? Should one man influence the world's largest market like that? What happens when he decides the time to kill the bubble?
How about the housing market? People called that a bubble for years. Should Greenspan come out and tell America too many people are buying houses and that ownership is bad, or that the working poor should be denied a chance for a home?
The problem with all these "solutions" is that they are political and top down. The best anyone can do is limit leverage and increase transparency. Anything else is an attempt to change human nature and it's desire to prosper as quickly as possible. A market is composed of participants and until the participants decide to do something, the market does nothing. Get with the program Baker.
December 19, 2008 11:08 AM | Reply | Permalink
shooter says:
I'm not an economist but I think you're mixing apples and oranges with your question about what Greenspan should tell America...
People who save and buy a house, and maybe a few years later buy a vacation home somewhere, or people who sell their first home and buy something better is the normal workings of the housing market and its not a bubble. To most of these people a 30 year fixed rate Mtg is the norm.
The bubble appears when you have easy money and way too many people in a feeding frenzy buying and selling houses not to live in, but simply to make a quick profit.
December 19, 2008 4:25 PM | Reply | Permalink
Not disagreeing with you, but I am quite sympathetic to those first time home buyers who watching the prices running away from them were terrified that they'd never get a chance at the American dream and felt they had to jump in.
On the other hand no matter how I may empathize with those buyers, my advice to them is to "walk away" -- and not to ask the rest of us to bail them out. America is full of second acts, and they'll have a second chance in a few years.
December 19, 2008 10:16 PM | Reply | Permalink
Ellen,
not disagreeing with you either. There are a number of groups responsible for this disaster,
unfortunately all I see is a bunch of people zeroing in on just one group, those unsophisticated people that were sold mortgages and houses they couldn't afford by sophisticated, educated people (sharks) who may have had business degrees and knew exactly what they were doing; selling crap to a "mark" to make a few bucks for the shark.
Perhaps we should pay more attention to the sharks who took part in this, the housing speculators, the originators, the wholesale mortgage purveyors, the investment banks, the corporate boys.
December 21, 2008 10:24 AM | Reply | Permalink
"Bubbles" aren't the problem!
And in the event no amount of "jawboning" will prevent or talk them down.
The real problem is an imbalance of world trade feeding into an insufficiently regulated banking system responsible for maintaining the world's reserve currency.
December 19, 2008 12:20 PM | Reply | Permalink
A little less cryptic ---
Stock market bubbles don't present significant risks to the financial system because 1) the markets are very liquid and 2) leverage is restricted. That is, post-1929 stock market participants who borrow from banks ("margin") can easily -- at some cost to themselves -- meet their debt obligations.
The problem, currently, is that the security the banks hold against the loans they made recently is illiquid because the resale markets are comparatively thin and because the securities are difficult to price. Apparently, the banks and their regulators treated these securities (ABSs, CDOs, MBSs, various forms of swaps, etc.) as if they were the equivalents of stocks and bonds. They now know they weren't.*
* Post-LTCM they were all supposed to have understood this fact -- so much for Santayana.
December 19, 2008 1:10 PM | Reply | Permalink
What! What! I can't believe what you saying, Ellen.
"Bubbles aren't the problem" Can't be prevented? My ass they can't be prevented. Asset bubbles appear in exaggerated form when extreme wealth is concentrated in the hands of a few elites like yourself no doubt. I'm reminded of the farmer who when he took his crop to sale and sat on the scale to add his own weight to the asset value. You act like valuations are never ever manipulated and no one ever has malicious intent except the people that are trying to help others. You lady, are the Alan Greenspan of this forum. You hide behind intellectual intricacy, and condescension so thick you'd need a back hoe to get through it. You show a lack of concern for anything other than your status as the one who knows everything. Mostly what you do is misdirect. I would assert that banks and their regulators knew what was going to happen and did it anyway. Madoff is about to be the sacrifice to appease the gods.
December 19, 2008 2:08 PM | Reply | Permalink
Uh-oh.
Somebody forgot to recharge the battery on Zeno's pill dispenser.
December 19, 2008 2:57 PM | Reply | Permalink
having a bad day sorry...
December 19, 2008 3:31 PM | Reply | Permalink
Bubbles are not a problem. Leverage within bubbles are the culprit. Who cares how overpriced a sector is if the banks can cover their positions? It's just money to be made or lost. What brought down Wall Street was not the inflated housing prices, it was the correction that resulted. The lenders and borrowers were overly leveraged which kicked off a margin call spiral with the predictable result of a massive sell off, tightening credit and deleveraging.
When the dotcom bubble burst those feeling the burn were those left with worthless shares of pets.com. Yes, the economy retrenched as the dotcom value evaporated. But is was a text book correction that had the misfortune of happening when the general economic indicators were already softening.
This time around the sector that got his was where we all live (literally). Again, softening indicators don't help. But the real ugly is the amount of leveraged exposure now that the bottom fell out.
The good news (if you don't work for one--which regrettably I do) is that the investment banks are gone; the last two running for the safety of Financial Holding Company status. Good by 33:1 leverage, hello 12:1; and with it 20-30% of net revenue. A huge number of hedge funds are next to fail, and then there will be very few highly leveraged firms.
The future looks bright!
December 19, 2008 6:36 PM | Reply | Permalink
And Dean Baker, you should be ashamed of yourself. "Bubble Talk"? Are you kidding me. I see, if we talk them down, the reasons they exist won't matter.... It's all good, as long as things don't get out of hand. It's OK to steal just don't get caught is more like it. The asset bubble in crude oil cost us hundreds of billions of dollars and sucked profits away from other aspects of our economy, which probably made this whole thing worse. WE BETTER DO MORE THAN TALK ABOUT BUBBLES IN THE FUTURE. ya think?
December 19, 2008 2:18 PM | Reply | Permalink
if we talk them down, the reasons they exist won't matter.
I don't think that you have correctly gleaned the kernel, as it were, of Dean's remarks.
Dean begs for "mere talk" because that is the low threshold that has been set when assessing the contribution of the professional/institutional economists.
I'm sure he would be all for a vigorous program of action such as the one you laid out...(um, what was the vigorous program you had in mind?)
December 19, 2008 3:07 PM | Reply | Permalink
Dean's (and Zeno's?) calls for heightened awareness/publicity of "bubbles" is objectionable, because it directs attention to the canaries and avoids informing the public of the real cause of the impending disaster -- the methane gas.
December 19, 2008 3:27 PM | Reply | Permalink
Reinstitute an aggressive tax system on the wealthiest 1% and in tax loop holes and incentives for everything from homes, to farming, and most importantly corporate income. Stop giving the rights of people to institutions, while taking away people's rights. The Employee's Free Choice Act would be a good place to start easing the one sided negotiations that have been taking place between Labor and Management recently. I believe we are in financial trouble as a country because the people at the bottom are tapped out due to government policies that only favor the monied elite. Bubbles become larger and larger as money is concentrated and tried to move from asset to asset trying to grow, like a black hole, it eventually collapses in on itself. There's an unnamable philosopher who predicted this happens over and over again. Because he an ideological pariah in our society no one considers his writing applicable.
December 19, 2008 3:47 PM | Reply | Permalink
unnamable
Ah yes, Harpo, the Marx who would not speak his name....
December 19, 2008 8:49 PM | Reply | Permalink
"if we talk them down, the reasons they exist won't matter.
I don't think that you have correctly gleaned the kernel, as it were, of Dean's remarks."
I was being snarky, if you add the "I see" to my comment.
December 19, 2008 3:50 PM | Reply | Permalink
Personal lawsuits for disagreeing with the Fed chair on the future direction of asset prices? Please tell me that was a joke.
The only thing such a plaintiff would get would be a swift and much-deserved kick in the ass from the judge. Oh yeah, and a hefty legal bill.
December 19, 2008 4:14 PM | Reply | Permalink
EOC,
stockholders can sue managers for exceptional incompetence. For example, if a bank were to leverage itself to its limits to place bets on soy futures and the bets went south, then the shareholders would have a case that the bank managers had been extraordinarily irresponsible (not just a mistake, but utterly reckless)and might have a case against them as individuals.
Similarly, if the execs had just chosen to ignore explicit and detailed warnings from the Fed chair (not disagree with, but completely ignore) they could face personal liability when their companies went bankrupt as a result. I'll let the jury decide this one.
December 19, 2008 5:19 PM | Reply | Permalink
Dean,
Much as I respect your economic analysis, I'm afraid you've got the law very wrong on this one. It's very well established that the business judgment rule protects executives' bets on the direction of asset prices. Moreover, executives have no duty to listen to the Fed chair's warnings on asset prices, much less carefully consider them. Ignoring the Fed chair's warnings is certainly not prudent, but it's not even close to actionable.
The courts have already decided this one, over and over again. Bad decisions, based even on the scantest information, are not actionable. Thus sayeth the Delaware Supreme Court.
December 19, 2008 7:40 PM | Reply | Permalink
Bubbles come and go. Bubbles SHOULD come and go. Ellen has it right. The problem is overleveraged parties and illiquid assets.
A few simple restrictions on financial intermediaries should work.
December 19, 2008 6:49 PM | Reply | Permalink
I unfortunately don't think it would have mattered at all if Greenspan had gotten up on the table at a Congressional hearing and screamed "these people are about to make a mess of the whole economy and take down a large number of innocent bystanders with them." It might have been fun to watch, but if the powers what wanted to keep doing what they were doing, he'd just be dismissed as a crazy old coot (not the bird) who was lost in the 20th century and should be replaced by someone who could get with the program.
We always want knowledge to be power, but the reality is that power determines knowledge.
December 20, 2008 6:36 PM | Reply | Permalink
Actually health care reform could be the major stimulus if we adopt public funding in place of employer paid health insurance. Layoffs are promoted in part by high benefit costs. Also they contribute to the weakness of the big 3 auto companies. One would greatly increase the employability and flexibility of workers if coverage were guaranteed by another source such as a national sales tax(delayed until recovery). Also health care is the major remaining American industry and could maintain employment. This spreads the stimulus to everyone and keeps the money in the economy.
December 21, 2008 3:44 PM | Reply | Permalink