Fredric Mishkin, former Fed governor, last week opined that all bubbles are not created equal, that only the credit variety are really damaging to the economy. The other kind of bubble – the internet, irrational exuberance variety – isn’t so bad and doesn’t do the sort of damage that the credit driven, real estate variety does. I suppose if one worked for the Federal Reserve in some capacity from 1994 to 2008 it is imperative for one’s self esteem to conclude that at least one of the bubbles you helped blow was benign in nature.
With bubbles seemingly on everyone’s mind these days, it seems a good time to discuss what exactly a bubble is and whether the Fed is currently sowing the seeds of another one as so many have recently wondered (see here, here, here and here). In Mishkin’s FT Op-ed he discusses two types of bubbles and if his inability to see Fed culpability in either case is typical of what is believed at the Federal Reserve, it is no wonder that monetary policy has been such a disaster over the last 30 years. Mishkin divides bubbles into two categories: “credit boom” and “pure irrational exuberance”. Of the credit boom variety, Mishkin says:
The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.
The astute observer will notice something missing from the explanation as to how such a bubble arises. Apparently in Mishkin’s view, the fact that the Federal Reserve cut and held interest rates at rock bottom levels had nothing to do with the expansion of this economically damaging credit bubble. I’m sure you remember the exuberant expectations about the economy during the last decade, right? And what about those structural changes in financial markets? Did those just occur out of thin air or did policy have anything to do with that? I guess the Fed had nothing to do with those changes either. Mishkin then describes the second type of bubble:
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.
How is it that Mishkin can write that paragraph and not make the connection between the Fed response to these popped bubbles and the subsequent credit bubble he so deplores? Does he not remember the S&L crisis and the low interest rates of the early 90s? Can he possibly believe that the Fed’s flooding of the economy with credit after popping the internet bubble had nothing to do with the mildness of the 2001 recession? If the popping of this type of bubble really causes no serious damage why did the Fed have to cut interest rates to 1% in response? If the Fed overreacted couldn’t that have been a causative factor in the subsequent credit bubble that is so damaging?
Mishkin goes on to say that tightening policy right now to restrain a possible bubble makes no sense. One can only assume that he believes either that the currently developing bubbles are of the benign variety or that no bubbles are currently forming. He’s a bit vague on that part, but he does believe that “(t)he Fed decision to retain the language that the funds rate will be kept “exceptionally low” for an “extended period” makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations.” So don’t worry, be happy, mon, and let the bubbles blow.
As you might guess, I don’t see things the way Mr. Mishkin sees them. What most people call the internet bubble, I call a rational response to the signals provided by the market distortions of the Federal Reserve. Likewise, what most people call the real estate or credit bubble, I believe was, again, a rational response to the conditions, created by the Fed, that prevailed at the time. The only thing that was irrational about either period was the belief that conditions would not change. When conditions did finally change, the response was again rational for the new set of conditions.
It is impossible to look at the stock market of early 2000 or the real estate market of 2006 and conclude that there was no irrational behavior. But irrational behavior doesn’t just happen; it is a response to real stimuli. The initial rise in the stock market of the 1990s was driven by investment that proved very beneficial to our economy. The rise in real estate and other real asset prices in the 2000s was driven by a lack of alternative investments and a desire, a need, to protect purchasing power that was being destroyed by a falling dollar.
The early part of the 1990s was spent cleaning up the S&L mess, but by the middle of the decade the US was a very attractive place to invest. The financial infrastructure of the US, much derided recently, was the envy of the world and investors enjoyed protections not available in other countries. The US, compared to many parts of the world, was politically stable with little difference between the two dominant political parties (at least not after the 1994 elections). Even more attractive was the environment of entrepreneurship that existed, particularly in Silicon Valley. The great technological developments of recent history happened here and the gain in productivity was (and in many ways still is) stunning. On top of all that, taxes were low and starting in the latter part of the decade, the government budget was near balance. Investing in the US in the mid 90s was a no brainer.
This confluence of positive factors lead to an inflow of capital and an increase in productive investment. The dollar rose against most foreign currencies and against real assets such as gold. Investors around the world saw good reasons to invest in the US. So much capital flowed here as a result that there came a point in the latter part of the decade when capital was no longer flowing here because of investment opportunities; it was flowing here for no other reason than the rising dollar. I do not believe this was an irrational choice on the part of the investors who sent their capital to the US but if there was a bubble in the late 90s, it was driven by a rising dollar. These investors believed that US economic policy would continue to support a rising value for the dollar. There is, however, a limit to the investment capacity of a country and the inflow of capital was so large and so fast that the economy could not produce enough worthy investment projects to absorb the capital. Instead it was used to fund projects so stupid only investment bankers could see the potential.
The Fed should have acted at some point in the late 90s to stem the rise in the dollar and stabilize it’s value. If that had happened, the flow of capital to the US would have slowed and the stupid internet projects of the late 90s would not have been funded. How they should have accomplished the stabilization is a topic for another day, but there seems little doubt that a signature problem of the US economy in the late 90s was too much capital chasing too few sound investment opportunities. I suppose this is what Mishkin believes is a good bubble.
The real estate bubble was a response to the lack of other investment opportunities in the US after the overinvestment of the late 90s. With no other attractive opportunities and low interest rates provided by the Fed, real estate attracted an increasing proportion of US investment. And once again, rising prices attracted more investment and the cycle described by Mishkin above took hold. Again the Fed could have prevented this situation if they had stabilized the value of the dollar in the middle part of the decade. As the dollar started to fall in 2001/2002, other real assets started to rise along with real estate. Gold bottomed in early 2001 and crude oil in 2002. Copper hit bottom in late 2001, platinum in the same year. Rising prices attracted new investment and as the dollar continued to fall, real assets captured more and more of US investment. These investments were not productivity enhancing as the ones in the 90s were and this lack of productive investment lies at the root of our current problems.
By 2003/2004, the dollar had returned to the levels of the mid 1990s and if the Fed had stabilized the dollar at those levels a good portion of the overbuilding in real estate would not have happened. Stabilizing the dollar at that point would have required tighter policy which would have choked off the flow of credit to the real estate market. I see no way to view the real estate market after 2004 as anything other than a direct result of faulty fed policy.
We are once again at a point where dollar stabilization is critical if we are to avoid much higher inflation in the future. The dollar is falling and investment is flowing into the non productive, real asset part of the economy. The problem facing the Fed is that if they act to stabilize the dollar now, the activity they’ve induced to this point which is being touted as economic recovery will come to an end. Monetary policy can foster real growth by producing a stable dollar environment or it can produce malinvestment, as we saw during the internet and real estate bubbles, by producing an unstable dollar environment, but real growth is a function of non monetary factors and it is there that we currently have a problem. Stabilizing the dollar at this point is more a matter of tax and spending policy than monetary policy.
Stabilizing the dollar requires attracting capital to the US and it is there that the US has failed dismally in recent years. The dollar has been declining since 2002 and government deficits have been persistently high, primarily due to the cost of fighting wars in Iraq and Afghanistan. Taxes are scheduled to rise in 2011 and our pending problems with Social Security and Medicare (not to mention what health care “reform” might do to the budget) mean taxes will have to rise even more in the future. Our attitude on trade has been nothing short of xenophobic. If investing in the US in the mid 90s was a no brainer so is investing elsewhere today. The Fed could probably stabilize the dollar now, but monetary policy does not happen in a vacuum. Unless we make the US a more attractive destination for capital, the consequences of stabilizing the dollar using monetary policy alone will be severe.
There will come a point where the Fed has no choice but to tighten policy to prevent a sharp rise in inflation and it is at that point that we will understand how bad our other economic policies have been. Until then, monetary policy will merely act to obscure the facts and allow the Obama administration to pursue unsound economic policies, just as it did during the Bush administration. The only bubble in the US right now is the belief in the ability of the government to borrow and spend our way to prosperity. That bubble, like all the others of the past two decades, will be popped by the Fed and when it does the consequences will be much more severe than anything we’ve seen to date.
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Weekly Economic and Market Review
There wasn’t much in the way of economic news last week. Many of the retailers reported earnings and the results were generally upbeat. Jobless claims dropped again but as I’ve said here many times, the drop is agonizingly slow and weekly claims are still above 500,000. Purchase mortgage applications plunged in the latest week which may give some insight into how much sales have been drawn forward by the tax credit. The credit has been expanded and extended but it might be that there no more sales to pull forward. Refinance applications by contrast rose smartly. Many have warned about the impending resets of option ARMS and other exotic mortgages, but I wonder if many of these might be refinanced before they reset. Or how many of them have already foreclosed. The trade deficit rose more than expected mostly due to higher oil imports. Part of the rise was due to higher volume and part was due to higher prices. I guess the rebalancing the G-20 talked about was just that – talk. Lastly, consumer sentiment came in worse than expected although I’m not sure why anyone would expect consumers to be cheery at this point. Job hunting is not good for consumer confidence.
Stock markets were up on the week with US stocks gaining roughly 2.5%. The S&P 500 still hasn’t closed over 1100 but that appears almost inevitable at this point. Sentiment is still negative and the public is still very skeptical of the rally. Domestic equity mutual funds are still experiencing outflows while bond funds are seeing record inflows. International equity funds, as would be expected from the discussion above, are attracting inflows that are almost exactly symmetrical with the outflows from domestic funds. I said above that the only bubble was in government worship but one potential area to listen to for popping sounds is the bond market. As I said above, at some point the Fed will have to stabilize the dollar and the most likely way to accomplish that is with much higher interest rates. Owning bonds, particularly Treasury bonds, when that happens promises to be a rather unpleasant experience.
It is tempting to pull in my horns here and take to the sidelines for the remainder of the year, but I think that would be a mistake at this point. The Fed shows no sign that they are concerned enough about the dollar to do anything about its continued drop and as long as that remains the case, risk assets should continue to rise. In a society with as much debt as the US, it should not be surprising that the central bank pursues an inflationary policy that favors debtors. Until the Fed is forced to tighten by the market, assets will rise in dollar terms. I do expect at some point to see the asset of choice shift from stocks to commodities and real estate again, but if you are diversified across asset classes that should not represent a problem. I remain bullish.
The S&P 500 is back near it’s highs:
Gold is extended and I am expecting a pullback:
I still favor platinum over gold. It looks better technically and it has more industrial uses than gold:
Agricultural commodities haven’t done much this year, but the ETF appears to have built a base. The long term fundamentals on agriculture are excellent:
The US dollar downtrend continues. I don’t expect any significant support until we reach the lows of summer 2008:
I think muni bonds have completed a correction:
Is the VIX building a base for a move higher? I don’t think so but it bears watching: