Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard – policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.


PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”



Leave a comment


  1. Bubbles in what? It is not always clear in your discussion. And while bubbles outside property markets are rare; in property markets, not so much.

  2. Lorenzo, I am on purpose not clear on that. I think of bubbles as economic wide misallocation of labour and capital. That could be into the construction sector and the real estate market, but that does not have to be the case even though it historically alway have been like that.

    Bubbles might emerge in many markets, but it is only important if it is having an economic wide impact.

  3. David Beckworth

     /  December 27, 2011

    Lars,now why did you have to go and embarrass me by providing a link to my dissertation:) Anyways, I do agree that the Fed’s effect on global asset prices was multiplied via its monetary superpower effect you alluded to above. I made a similar point in my monetary superpower paper with Chris Crowe:

  4. David, it is an excellent dissertation! And you have been trying to hide it, but I tracked it down;-)

    Concerning US versus global monetary policy I actually think it might be worth looking at whether global monetary conditions became too loose, while US monetary policy from a strictly NGDP targeting perspective was more neutral. My idea is to have a look at earnings growth in US companies and comparing that with global and US NGDP growth. My guess is that US earnings growth correlate better with global NGDP than with US NGDP and as a result you might have had Selginian relative inflation in the indirect sense in the US despite this not being visible in the US NGDP numbers.

  5. David Beckworth

     /  December 28, 2011

    Interesting idea, the tough part I suspect will be coming up with a good global NGDP measure at a high enough frequency to do analysis. I made one once before interpolating the IMF’s annual series they occasionally put in the WEOs.

    I also did this post sometime ago using the annual IMF data:

  6. I think of bubbles as economic wide misallocation of labour and capital. Surely, bubbles don’t have to be economy-wide: some parts of the US had housing bubbles and some parts did not. Which did and did not is very revealing about the nature of (housing) bubbles.

    I am also uncomfortable with the notion of ‘misallocation’, given it is clear only in retrospect. It is also rather close to the notion of ‘malinvestment’, a concept I have serious disagreements with.

  7. David, I have been using the same global data from WEO. Interestingly the increase in for example global commodity prices correlated quite well with global NGDP so the concept clearly seem to be valid. Does that mean that we are in the midst of a global bubble? I don’t think so, but obviously if we argue that it is a problem that NGDP has fallen well below pre-crisis trend in the US and Europe then we should be equally worried if the there are signs of excessive demand inflation (NGDP above trend and relative inflation) in other countries – primarily Emerging Markets.

  8. Lorenzo, I acknowledge that “misallocation” sounds a bit Austrian and to some extent is the same as the Austrian concept of “malinvestment”. What I sketch, however, is not a version of the Austrian business cycle theory even though there are some similarities. Unlike the Austrians I do not believe to be bubbles to be widespread and I do not think that we get “malinvestment” if monetary policy occasionally become overly easy.

    That said, I do think there is a very clear risk that overly easy monetary policy and moral hazard (implicit or explicit guarantees to investors) can create the wrong incentives to take excessive risk. This does not seems to be like a risk that we should be concerned about in the euro zone or the US right now, but for other countries these considerations might be fully valid, cf. the discussion between David and me on global NGDP.

    Lets take China, in China there is serious misallocation of capital and labour due government intervention in the economy. The Chinese government quite clearly has helped spur what could be seen as a Chinese property market bubble and the People’s Bank of China (the central bank) has helped this process by sharply increasing the money supply. I am not certain we are in the midst of a economic wide Chinese bubble, but we should certainly not be ignorant to these risks.

    Finally in regard to bubbles as being economic wide or not my point is that we can have “bubbles” in a lot of market in the sense that investors make the wrong decisions and prices increases more than “dictated” by fundamentals but that is just the nature of things in an uncertain world. Investors make mistakes all the time and that is not a major problem. This mistakes are corrected over time in the unhampered market. Therefore, I only think that economic wide bubbles are relevant in terms of discussion monetary policy – and even here as I stress above – I don’t think that the central bank should be in the business of pricking bubbles.

  9. It is only a wrong decision if you get caught (by events).

    The term ‘mistake’ is ambiguous. There are mistakes where, given the information available at the time, the decision was faulty. And there are mistakes where, given information that subsequently became available, it was the wrong decision. The first imply some sort of culpability, the second do not (at least, not by the individual agents).

    To me, the key thing about bubbles is that the turning point is unknown prior to the event. If was predictable, people would not be caught by it. So, it creates many mistakes in the second sense, but just the normal proportion in the first. The key story is expectations, not misallocation.

    Assets are some mixture of income source (bonds are pure income source) and stores of value (gold kept as bullion is a pure store of value). The reason property markets are particularly prone to bubbles is that land can apparently function as a store of value. Once the expectation is set up that it is an inflation-beating store of value, rising prices then feed themselves since they set up expectation-reinforcement-loops. One can get overbuilding in commercial property but housing bubbles are rarely significantly marked by over-building. On the contrary, they are more likely to be a result of (land) supply constraints creating elevated notions of land as (rising) store-of-value. (Hence some jurisdictions can suffer major housing booms and busts — California, UK, Japan — and others much less so or not at all — Texas, Germany.) Housing bubbles tend to have rather more excess debt than labour or capital misallocation.

  10. W. Peden

     /  December 29, 2011

    A very good post that touches on issues that I’ve been thinking about recently and makes them much clearer for me.

    Two points-

    (1) Whether or not there was a rise in relative rise in inflation in the US prior to 2008 depends on the prices that you look at. Prices of consumer goods certainly weren’t out of control. Oil prices were high, but due to unambigious supply shocks. Property prices, stock markets and other assets however did follow a path of rapid inflation from about 2003 to 2005, followed by a levelling off in 2006 and a sharp contractionary phase in 2007-2008. You could call this a boom in PT while PY was growing steadily and sustainably; another term for it would be a “financial boom”, which I suspect will become more common as financial sectors increase in importance.

    (2) On the issue of imported inflation, this is definitely an interesting phenomenon. The OECD broad money supply tends to march in step with the Fed-

    – presumably because sterilising the effects of Fed-originated monetary expansions is politically very difficult.

  11. W Peden, thank you for your comments.

    Your reference to the Bank of England story reminded me that I have actually done some calculations on the split between demand inflation and supply inflation in the UK (based on the Quasi Real Price Index). In the UK it is very clear that monetary policy was excessively loose basically since the early 1990s. There has been very significant supply deflation over the past two decade (thank you Baroness Thatcher!). I think this might very well help explain the strong rise in UK property prices in the “boom-years”.

    I would also argue that for some assets global NGDP growth rather than domestic NGDP is more important. Take for example the US stock markets – I think global NGDP expectations will do a better job explaining the development in US stocks than US NGDP expectations. That said, I am not sure that global monetary conditions were overly loose just prior to 2008.

    By the way, I am not sure oil prices really are that high. On should note that while US and Europe NGDP grew fairly strong from 1998 until 2008 (around 5%) that was not the case of most Emerging Markets – especially for the Asian countries. In fact we had demand deflation from around 1998 and until 2002-4. That kept oil prices very low in that period and when global NGDP then started to rebound from 2002 or so oil prices (and other commodity prices) started to pick up. In my view the development in commodity prices can quite easily be explained by global NGDP in the last couple of decades and we can basically ignore supply concerns.

  12. W. Peden

     /  December 29, 2011

    Lars Christensen,

    I’m surprised to hear that data about oil prices. I suppose they seemed high during the period because (a) the contrast was with the 1986-2003 period and (b) oil in the UK was not getting cheaper while almost every other importable good was getting cheaper.

    I’m also interested to hear that about UK NGDP. I was aware that our broad money growth from about 2004-2008 was far above our real output-

    – and that there was a “mini-boom” at the end of the last Tory government that was thankfully slowly deflated by the Bank of England in 1998-

    – but I wasn’t aware that there was more solid evidence suggesting that. Unfortunately, the previous government seems to have steadily eroded the UK’s supply-side strengths over the past 10 years. I suppose we usually wish we could have yesterday’s problems!

    I agree with your point about the effects of global nominal growth on asset prices. It couples nicely with David Smith’s work: the interaction of asset prices, broad money and nominal GDP (not in any particular order) takes place at the global level as well as the national level.

  13. W. Peden

     /  December 29, 2011

    Off-topic: here’s another good BoE graph from the same place that adds more evidence to the theory that the tightening of monetary conditions preceded the main financial crisis in late 2008. British money supply expansion seizes up for the leading sectors of the economy in late 2007/early 2008-

  14. “it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles”

    This is patently false.

    Bubbles are almost always due to bank credit creation, fraud & the “miracle of compound interest”.

    Most credit today is spent to buy assets already in place, not to create new productive capacity.
    The effect of extending bank credit for assets already in place is to bid up their price.
    It is this increase in private debt bidding up asset prices that makes bubbles possible not “loose monetary policy”

    But it is fraud that, by enabling the rapid increase of bank credit, provides the fuel to hyperinflate bubbles.
    Fraudulent loan origination causes an enormous expansion of bank credit that would otherwise be impossible.
    Bank credit creation is normally limited by the number of credit worthy borrowers (those able to repay) and can only expand beyond this by making loans to those non-credit worthy borrowers unable to repay.

    Here the weapon of choice is Accounting Control Fraud.
    Control frauds cause greater losses than all other forms of property crime combined.

    The epidemic of mortgage fraud perpetrated by these Accounting Control Frauds was essential to the creation of the largest bubble in history, the U.S. housing bubble.

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