All posts tagged Bubbles

The stock market remains at a “permanently high plateau”

Nearly a year ago I in a response to Fed Chair Janet Yellen’s apparent concerns over the valuation of the US stock market argued – echoing Irving Fisher’s ill-fated views from 1929 – that the US stock market had reached a “permanently high plateau”.

Over the last year US stock prices have continued to inch up (Wilshire 5000 is up around 7% since I wrote the post last year), but recently we have seen a bit of market volatility. So I thought it could be interesting to re-visit the arguments I made a year ago and see whether we still can argue that stocks are on a permanently high plateau.

But let me first repeat the disclaimer from last year – this is not investment advice, but rather a quasi-academic exercise. In fact I have no illusions that I am able to beat the market. This is rather about illustrating whether or not one can argue that there is a bubble in the US stock market as some commentators have argued.

My version of the “Fed model”
In my post last year I used a variation of a valuation “model”, which is popular with equity strategists – the so-called Fed model.

Essentially the Fed model says that stock prices are determined by the so-called earnings yields, which is the ratio between earnings and bond yields.

In my version of the Fed model I do not use earnings, but rather Private Consumption Expenditure (as an monthly approximation for nominal GDP – which over time should move hand in hand with earnings) and a corporate bond yield (Moody’s Aaa rated bonds). We can call the ratio between PCE and the corporate bond yield “fundamentals”.

The graph below shows the development in the Wilshire 5000 stock market index compared to “fundamentals”. I have – like a year ago – used January 1980 as the “starting point”. This is partly arbitrary, but also ensures that the two variables over the entire period more or less have the same average.

Wilshire fundamentals 19752015

The picture is pretty clear – over the past 40 years stock prices over the medium term have tended to track “fundamentals” (measured in our rudimentary way) pretty closely. There are only two periods where the actual stock market performance has diverged from “fundamentals” and that is during the “tech bubble” in second half the 1990s (where the stock market overshot “fundamentals”) and during the past seven years (where the stock market undershot “fundamentals).

This by the way also illustrates that the part of rise in US stock prices since 2009, which can not be explained by higher nominal spending (nominal earnings) or lower bond yields can be explained by a “normalization” of the risk premium on stocks, which spiked on the back of the financial and monetary shock in 2008.

In the graph below we zoom in on the Great Recession period.

Wilshire fundamentals 20082015

The graph is pretty clear – the recent increase in bond yields (we are up around 75bp since the beginning of the year) has caused “fundamentals” drop, but that drop just brings actual stock prices and “fundamentals” in line with each other so the actual level for the Wilshire 5000 now is nearly perfectly aligned with “fundamentals” (there is less than a quarter of a percentage difference between the two).

I do of course not argue that this is the entire story about the stock market valuation and one can certainly question the Fed model (and my variation of it) on theoretical grounds, but I on the other hand find it very hard based on a empirical relationship that have held up quite well for at least 40 years to argue that there is a bubble in the US stock market.

What would make the stock market crash?

What I argue above is that it is hard to argue that the US stock market is overvalued. However, that does certainly not mean that stock prices can not plumment. In fact when the US stock market collapsed in 2008-9 it was at a time when our “model” was telling us that stock prices was not overvalued either.

So what could cause the stock market to plumment once again? Well, the easiest way to look at it is to look at the three factors in our “model”.

First of all the level of nominal spending (here approximated by PCE), second the bond yield and finally a risk premium, which essentially is the residual between the actual level for stock prices and “fundamentals”.

We know that nominal spending in the economy is determined by monetary conditions so one reason for a possible drop in stock prices could be that the Federal Reserve moves to tighten monetary conditions faster or more than expected by investors. That would cause a drop in nominal spending (and nominal earnings), which in our model would cause a drop in stock market “fundamentals”.

A tightening of monetary conditions (relative to market expectations) could also cause an increase in bond yields through a liquidity effect. This would also push down “fundamentals” in our model. Hence, a faster than expected tightening of monetary conditions would cause stock prices to drop through these two channels.

A third channel is an increase in the risk premium on stocks. This also could be caused by an excessive monetary tightening, but there are certainly also other factors that could cause such a spike in the risk premium – for example a Greek euro exit, Chinese financial distress, increased geopolitical tensions, a supply-driven spike in oil prices etc.

This is all possible and all these factors could cause US stock prices to drop. However, there might equally be arguments for the opposite – that for example markets are wrong about the timing the first Fed rate hike. If the Fed for example where to come out and say that nominal spending growth is disappointing and rate hikes will be postponed until next year then that would cause an increase in the “fundamentals” in our model.

A reality check – not a “predictor”

So what I have been arguing in this post – like a year ago – is that US stock prices more or less reflect “fundamentals” (in a quite rudimentary form). However, I have also stressed that that on it own does not tells us anything about what will happen to stock prices in the future. My variation of the “Fed model” is not a “predictor” of future stock market gains. It is a simple reality check on the valuation of the US stock market. So use it carefully!

PS I would normally get comments on these kind of posts from “internet Austrians” who would claim that bond yields are artificially low because they have been “manipulated” by the Federal Reserve. Well, lets just say that I believe that low bond yields in general mostly reflect expectations for long-term nominal spending growth and a risk premium (positive or negative), but if you think that the US government is about to go bankrupt and yields will spike dramatically then feel free to sell your stocks. Again I am not providing investment advice.

—-

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com – or myself (lacsen@gmail.com)

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2 Comments
by Lars Christensen on June 10, 2015  •  Permalink
Posted in Bubbles, Fed model, Stock market valuation, Wilshire 5000
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Posted by Lars Christensen on June 10, 2015

https://marketmonetarist.com/2015/06/10/the-stock-market-remains-at-a-permanently-high-plateau/

There is no bond market bubble

Bubbles, bubbles, everywhere bubbles. There is a lot of talk about bubbles among commentators and central bankers. One of the most common bubble fears is a fear of a bubble in the US bond market (just take a look at this recent “bond bubble”-story). Generally I am very skeptical about all kinds of bubble fears and that also goes for the fear of a bubble in the US bond market.

The general bond bubble story more or less assumes that quantitative easing from the Federal Reserve and other central banks has pushed down bond yields to artificially low levels and once QE is over the bond bubble will burst, bond yield will spike dramatically and send the US economy back into a major recession.

Should we fear this? Not really in my mind and I will try to show that in this blog post.

Inspired by Krugman and Mankiw

I very often disagree with Paul Krugman, but no one can dispute that he is a great communicator. Krugman is able to present complicated economic stories in a few sentences. This is exactly what he did in one of my favourite Krugman-blog posts back in 2010. The topic of the post was exactly the “bond bubble”. This is Krugman:

Here’s a thought for all those insisting that there’s a bond bubble: how unreasonable are current long-term interest rates given current macroeconomic forecasts? I mean, at this point almost everyone expects unemployment to stay high for years to come, and there’s every reason to expect low or even negative inflation for a long time too. Shouldn’t that imply that the Fed will keep short-term rates near zero for a long time? And shouldn’t that, in turn, mean that a low long-term rate is justified too?

So I decided to do a little exercise: what 10-year interest rate would make sense given the CBO projection of unemployment and inflation over the next decade?

… I decided to use the simplified Mankiw rule, which puts the same coefficient on core CPI inflation and unemployment. That is, it says that the Fed funds rate is a linear function of core CPI inflation minus the unemployment rate.

Krugman is basically using the Mankiw rule to forecast the Fed funds rate 10 years ahead and then he compared this forecast with the 10-year US government bond yield. It turned out that the 10-year yield was pretty well in line with the forecasted path for Fed Funds rates. I will now show that that is still the case.

Using the Mankiw rule to predict US monetary policy 10-years ahead

I have recently been playing a bit with the Mankiw rule (see here and here) so it is only natural to re-do Krugman’s small “experiment”.

Krugman is using CBO’s projections for core PCE inflation and unemployment. I will do the same (see the latest CBO forecast here) thing, but I will also use the FOMC’s recent projections (see here) for the same variables. I plug these projections into the Mankiw rule that I recently estimated. This gives us two forecasts for the Fed funds future rate for the coming 10-years. The graph below shows the two “forecasts”.

Mankiw rule FOMC CBO

Both forecasts (or maybe we should say simulations) point to interest rate hikes from the Fed in coming years. The forecast based on FOMC projections for unemployment and core inflation is a bit more “aggressive” in the rate hiking cycle than the Mankiw rule based on the CBO forecasts for the same variables.

The reason for this is primarily that the FOMC members expect unemployment to drop faster than forecasted by the CBO. Both the FOMC and CBO expects inflation to gradually increase to 2% over the coming 4 years.

The rule based on the FOMC projections indicates that the Fed funds target rate should be close to 3% in the “long run” (after 2018), while the CBO based rule is indicating a Fed funds rate around 2.6% i the long run. This difference is due to the FOMC expects unemployment at 5.0% in the long run, while the CBO expects unemployment at 5.5% in the long run.

I should stress that this is not my forecasts for the Fed funds rate as such, but rather an illustration of how we should expect the Fed’s policy rate to development over the coming 10 years if the Mankiw rule in general holds and we use the FOMC and CBO’s macroeconomic forecasts as input in this rule.

Drawing a (simplified) yield curve

We can now use these “predictions” to construct a (quasi) yield curve. Not to make things overly complicated (and spending to much time calculating the stuff…) I have simply constructed the “yield curve” by saying that “forecast” for for example the 2-year yield is simply the average of the predicted of the Fed funds rate in 2014 and 2015. Similarly the 5-yield is the average of the forecasted policy rate for 2014-2019. Hence, I disregard compounded interest and coupon payments.

The graph below shows the actual US yield curve compared with the two quasi-yield curve based on the two Mankiw rule based predictions for the Fed funds rate in the coming 10 years.

yield curve Fed Mankiw

Looking at the graph we imitatively spot two things:

First of all we see that the FOMC curve and CBO curve are considerably “higher” than the actual yield curve for the next couple of years. This should not be a surprise given the fact that we already know that forecasts based on the Mankiw rule is too “hawkish” compared to the actual Fed policy in 2014. Hence, the “predicted” rate for 2014 is 75-100bp too high. The reason for this is among other things that the simple Mankiw rule does not take into account “discouraged worker”-effects on the labour market, which seems to have been a a major problem in the past 5-6 years. Furthermore, the rule ignores that the Fed over the past 5-6 years more or less consistently has undershot it’s 2% inflation target. I have discussed these factors in my previous post.

These factors mean that we should probably pushed down the “rate path” in the next couple of years and that means that the yield curve does not look to be too “low” for 2-year or 5-years (very broadly speaking).

Second, we see that if we look at the 10-year yield we see that it is more or less exactly where the FOMC curve “predict” it to be (around 2.6%). We can of course not directly compare the two as I have not taken compounded interest and coupon payments into account (which would push the FOMC curve up), but on the other hand we should also remember that the Mankiw rule is too “hawkish” for the “early period” (which should push the FOMC curve down along the curve).

There is no “bond bubble”

I believe that the discussion above shows that US bond yields pretty well reflect realistic expectations to Federal Reserve policy over the coming decade given the FOMC’s and the CBO’s expectations for US unemployment and core inflation and it is therefore hard in my view to justify the claim that there is a bubble in the US bond market. That of course does not mean that yields cannot go up. They very likely will if FOMC’s and CBO’s expectations particularly for the US labour market are correct.

And the bond market might of course also be 50bp wrong is one or the other direction, but I find it very hard to see why US bond yields should suddenly spike 200 or 300bp as some of doomsayers are claiming.

And finally I should stress that this is not investment advice and I am not making any recommendations to sell or buy US Treasury bonds and the market might go in whatever direction.

Instead my point here is to argue that policy makers – the Fed – should not be overly concerned that quantitative easing has caused a bond bubble. It has not. If anything bond yields are this low because the Fed has not eased monetary policy enough rather than too much.

Related posts:

There is no bubble in the US stock market

The stock market has reached “a permanently high plateau” (if the Fed does not mess up again…)

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

8 Comments
by Lars Christensen on September 20, 2014  •  Permalink
Posted in Bonds, Bubbles, Federal Reserve, Greg Mankiw, Mankiw rule, Paul Krugman
Tagged , , , , ,

Posted by Lars Christensen on September 20, 2014

https://marketmonetarist.com/2014/09/20/there-is-no-bond-market-bubble/

Stock picker Janet Yellen

If you are looking for a new stock broker look no further! This is Fed chair Janet Yellen at her testimony in the US Senate yesterday:

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

This is quite unusual to say the least that the head of most powerful central bank in the world basically is telling investors what stocks to buy and sell.

Unfortunately it seems to part of a growing tendency among central bankers globally to be obsessing about “financial stability” and “bubbles”, while at the same time increasingly pushing their primary nominal targets in the background. In Sweden an obsession about household debt and property prices has caused the Riksbank to consistently undershot its inflation target. Should we now start to think that the Fed will introduce the valuation of biotech and social media stocks in its reaction function? Will the Fed tighten monetary policy if Facebook stock rises “too much”? What is Fed’s “price target” in Linkedin?

I believe this is part of a very unfortunate trend among central bankers around the world to talk about monetary policy in terms of “trade-offs”. As I have argued in a recent post in the 1970s inflation expectations became un-anchored exactly because central bankers refused to take responsibility for providing a nominal anchor and the excuse was that there are trade-offs in monetary policy – “yes, we can reduce inflation, but that will cause unemployment to increase”.

Today the excuse for not providing a nominal anchor is not unemployment, but rather the perceived risk of “bubbles” (apparently in biotech and social media stocks!)  The result is that inflation expectations again are becoming un-anchored – this time the result, however, is not excessively high inflation, but rather deflation. The impact on the economy is, however, the same as the failure to provide a nominal anchor will make the working of the price system less efficient and therefore cause a general welfare lose.

I am not arguing that there is not misallocation of credit and capital. I am just stating that it is not a task for central banks to deal with these problems. In think that moral hazard problems have grown significantly since 2008 – particularly in Europe. Therefore governments and international organisations like the EU and IMF need to reduce implicit and explicit guarantees and subsidies to (other) governments, banks and financial institutions to a minimum. And central banks should give up credit policies and focus 100% on monetary policy and on providing a nominal anchor for the economy and leave the price mechanism to allocate resources in the economy.

9 Comments
by Lars Christensen on July 16, 2014  •  Permalink
Posted in Bubbles, Federal Reserve, Janet Yellen, Uncategorized
Tagged , ,

Posted by Lars Christensen on July 16, 2014

https://marketmonetarist.com/2014/07/16/stock-picker-janet-yellen/

There is no bubble in the US stock market

Before you start reading this post note that I am not an equity market analyst and this is not investment advice. Rather it is an attempt to discuss the impact of monetary easing on the US stock market and to what extent the Fed’s actions have created a stock market bubble.

It is quite often said these days that the recovery we have seen in the US stock markets since early 2009 in some way is “phony” or “fake”, and that it has been driven by “easy money”. Even some policy makers, both in the US and other places, seem to think that there is a bubble in the global stock markets, which is a result of overly easy monetary policy.

To test these views in a simple way, I have estimated a model for the S&P500 going back to 1960.  It is a simple OLS regression. You can do something more fancy, but that is not the point here. It is all indicative. If you have a better model, I would love to see it.

Take a look at the graph below. The blue is the actual performance of S&P500, while the green line is the model “prediction”. Please note that I have estimated the model until 2007 to avoid the results being influenced by the monetary policy shift over the past five years (it doesn’t change the result in any substantial way, however, to estimate the model until today).

SP500 model

As you see, the model fits the actual performance of S&P500 over the decades quite well. The model is quite simple. I used only three explanatory variables – A corporate Aaa-rate long-term bond yield to capture funding costs and/or an alternative investment to stocks. I used the nominal Personal Consumption Expenditure to capture demand in the US economy. It is also a proxy for earnings growth and finally I used the ISM New Orders index as a proxy for growth expectations. All variables have the expected signs and are statistically significant.

Yes, it is a simple model, but it seems to work quite well in terms of fitting the actual level on the S&P500 over the years.

If anything stocks are still cheap (and monetary policy too tight)

As mentioned, I estimated the model with data until 2007, but I have used the model to “predict” how the stock market should have performed according to the model from 2008 until today.

The results are quite clear: Since 2008, stock prices have consistently been lower than what the model predicts. Only recently have stock prices approached the level predicted by the model. Based on this, it is quite hard to argue that stock prices in the US are overvalued. In fact if anything stocks remain “cheap” relative to the model predictions.

I don’t want to argue this too strongly and I am certainly not giving any advice on whether to buy or sell the US stock market at these levels – all kind of things tend to move the market up and down. What I am arguing is that the view that there is a bubble in the US stock market is pretty hard to justify based on my simple model. If you can come up with a better model, which can show that there is a bubble, I am all ears.

Therefore, it is very hard to argue in my view that overly easy monetary policy has distorted the pricing of US stocks. What has happened rather is that stocks became extremely cheap relative to “fundamentals” in early 2009, and what we have seen in the past five years is a closing of this “valuation gap”. Has monetary policy helped close the “gap”? Yes, that is likely, but that is not the same as saying that there is a bubble.

Concluding, there is no empirical reason in my view to claim that US monetary policy has unduly inflated US asset prices. And hence the performance of the US stock market over the past five years is not an argument for monetary tightening. It anything it is an argument that monetary policy has remained too tight.

—

PS if you are interested in the model output see below (it is not rocket science):

  • Model 1

    S&P500, rebase 01-01-1960 = 100.0

    • Observations 576
      Degrees of freedom 572
      R2 0,9597105111
      F 4541,7504443086
      Prob-value(F) 0
      Sum of squared errors 16279,404325032
      Standard error of regression 5,3348380549
      Durbin-Watson 0,0489587816
      AIC 6,1933143441
      HQ 6,2051117912
      Schwarz 6,2235650918
    • Coefficients Standard error t Prob-value
      Intercept -627,703293948 7,0591041987 -88,9210976745 0
      x1 -3,4836423233 0,096018312 -36,2810202582 0
      x2 28,8240799392 0,2485205896 115,9826635779 0
      x3 -0,0228854283 0,0303242775 -0,7546899778 0,4507456199
    • Legend
      x1 Corporate Benchmarks, Moody’s Aaa-Rated Long-Term, Yield, Average, USD
      x2 PCE
      x3 ISM PMI, Manufacturing Sector, New orders, SA
    • Covariance matrix
      Intercept x1 x2 x3
      Intercept 49,8309520883 0,0191128279 -1,6803093367 -0,067856727
      x1 0,0191128279 0,0092195162 -0,0048925278 0,0007896205
      x2 -1,6803093367 -0,0048925278 0,0617624835 0,0003876941
      x3 -0,067856727 0,0007896205 0,0003876941 0,0009195618
13 Comments
by Lars Christensen on December 10, 2013  •  Permalink
Posted in Bubbles, Uncategorized
Tagged

Posted by Lars Christensen on December 10, 2013

https://marketmonetarist.com/2013/12/10/there-is-no-bubble-in-the-us-stock-market/

You have to thank Scandinavian Airlines for this post – kind of a tribute to Nouriel Roubini

Dear friends if you like to read my blog posts you will have to thank Scandinavian Airlines for this one. I am stuck in Heathrow Airport for now. Cancellations and delays of my flight from London to Copenhagen mean that this has been a rather unproductive day. However, that is part of the life as a traveling standup comedian/economist – we spend a lot of time in airports. Today, however, has been a bit too much – particularly taking into account that my next trip will be on Wednesday.

The purpose of my next trip is to go to Lithuania where I will be battling it out with Dr. Doom aka Nouriel Roubini. Nouriel and I have known each other for 6-7 years. We used to agree that we were heading for trouble and we also agree that the ECB failed on monetary policy. But fundamentally Nouriel is a Austro-Keynesian – a position that I strongly disagrees with. The Austro-keynesian perception of the world, however, is very common these days: During the later years of the Great Moderation we overspend and as a result we are now having a hangover in the form of repaying debt and therefore having lower private consumption growth and lower investment growth. It is not clear why we overspend – the Austro-keynesians tend to believe that it was a combination of overly easy monetary policy and “animal spirits” that did it. I think this story is utterly wrong, but nonetheless it seems to be the majority view these days.

For the last four years Nouriel has been negative about the world. That to some extent has been right, but for the wrong reasons. Nouriel never forecasted that the ECB would fail so utterly – even though he correctly has criticized the ECB for overly tight monetary policy he certainly did not forecast how events played out.

In general I am very skeptical about making heroes out of people who got it right in 2008 – whether it is Nouriel Roubini or Peter Schiff or for that matter myself and my ultra negative call on Iceland and Central and Eastern Europe in 2006/7. The fact is that most of the people who got it right in 2008 had been negative for years (including myself who turned bearish in 2006). Peter Schiff for example has been screaming hyperinflation for years. He has been utterly wrong about that. Roubini has been negative on the US stock market for years. He has been utterly wrong on that. I was right about being negative about Iceland, but the bullish call I made on Iceland a year ago or so actually has been much more correct than my negative call in 2006 (it took much longer for the crisis to materialize than I expected), but nobody cared about that because being bullish is never as “fun” as being negative.

If all economists in the world throw out random forecasts all time some of them will be right some of the time. The more crackpot forecast you make the more spectacularly correct they will seem to be when they happen. Nassim Taleb even got famous for saying that rare events (“black swans”) happen and then a black swan event happened. Taleb didn’t forecast anything. But he is a celebrity anyway. Paradoxically the logic of his argument is that you can’t forecast anything and despite of that he is telling people how to invest based on this.

I am proud of the few things I forecasted right in my life, but frankly speaking getting a forecast right doesn’t make you a good economist. The popular press was suggesting that Robert Shiller should get the Nobel Prize for forecasting both the bust of the IT bubble and the property market bubble. Please come on – that is not the work of an economist, but that of gambler. Robert Shiller is a clever guy, but I don’t think his biggest achievement is forecasting the bust of two bubbles – that is just pure luck (I had similar views to Shiller in both cases, but do not claim to be a great forecaster). Shiller’s biggest achievement is his work on what he calls “macro markets” and his book on that topic. That work has gotten absolutely no attention, but it is very clever and significantly more interesting than his work on “bubbles”.

My friend Nouriel Roubini is a great economist, but my respect for himhas nothing to do with his bearish calls on the global economy. I, however, was a huge fan of Nouriel well before he made those bearish forecasts and before I ever met him. Nouriel has done amazingly good work with among others Alberto Alesina on political business cycles and the use of game theory in understanding monetary and fiscal policy. That didn’t make Nouriel an economic superstar, but it inspired me to study these topics. So I am forever grateful to Nouriel for that.

So Nouriel see you in a few days. As always it will be great seeing you. We will argue and you will tell me – as usual – that I am overly optimistic despite my gloomy view of the world and my distrust of policy makers. But no matter what it will be great fun. See you in Vilnius! And if you haven’t been to that great city before I am sure I will have time to show you a bit of it.

11 Comments
by Lars Christensen on October 22, 2012  •  Permalink
Posted in Bubbles, Nouriel Roubini
Tagged ,

Posted by Lars Christensen on October 22, 2012

https://marketmonetarist.com/2012/10/22/you-have-to-thank-scandinavian-airlines-for-this-post-kind-of-a-tribute-to-nouriel-roubini/

Dangerous bubble fears

Here is Swedish central bank governor Stefan Ingves in an op-ed piece in the Swedish newspaper Svenska Dagbladet last week:

“I also have to take responsibility for the long term consequences of today’s monetary policy…And there are risks associated with an all too low interest rate over a long period, which cannot be ignored.”

Said in another way if we keep interest rates too low we will get bubbles. So despite very clear signs that the Swedish economy is slowing Ingves would not like to ease monetary policy. Ingves in that sense is similar to many central bankers around the world. Many central bankers have concluded that the present crisis is a result of a bubble that bursted and the worst you could do is to ease monetary policy – even if the economic data is telling you that that is exactly what you should.

The sentiment that Ingves is expressing is similar to the view of the ECB and the fed in 2008/9: We just had a bubble and if we ease too aggressively we will get another one. Interestingly enough those central banks that did well in 2008/9 and eased monetary policy more aggressively and therefore avoided major crisis today seem to be most fearful about “bubbles”. Take the Polish central bank (NBP). The NBP in 2009 allowed the zloty to weaken significantly and cut interest rates sharply. That in my view saved the Polish economy from recession in 2009 – Poland was the only country in Europe with positive real GDP growth in 2009. However, today the story is different. NBP hiked interest rates earlier in the year and is now taking very long time in easing monetary policy despite very clear signs the Polish economy is slowing quite fast. In that sense you can say the NBP has failed this year because it did so well in 2009.

The People’s Bank of China in many ways is the same story – the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.

So the story is the same in Sweden, Poland and China. The countries that escaped the crisis did so by easing monetary conditions. As their exports collapsed domestic demand had to fill the gap and easier monetary policy made that possible. So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments. However, this now seem to be a major headache for central bankers in these countries.

I think these bubble fears are quite dangerous. It was this kind of fears that led the fed and the ECB to allow monetary conditions to become excessive tight in 2008/9. Riksbanken, NBP and the PBoC now risk making the same kind of mistake.

At the core of this problem is that central bankers are trying to concern themselves with relative prices. Monetary policy is very effective when it comes to determine the price level or nominal GDP, but it is also a very blunt instrument. Monetary policy cannot – and certainly should not – influence relative prices. Therefore, the idea that the central bank should target for example property prices in my view is quite a unhealthy suggestion.

Obviously I do not deny that overly easy monetary policy under certain circumstances can lead to the formation of bubbles, but it should not be the job of central bankers to prick bubbles.

The best way to avoid that monetary policy do not create bubbles is that the central bank has a proper monetary target such as NGDP level targeting. Contrary to inflation targeting where positive supply shocks can lead to what Austrians call relative inflation there is not such a risk with NGDP level targeting.

Let’s assume that the economy is hit by a positive supply shock – for example lower import prices. That would push down headline inflation. An inflation targeting central bank – like Riksbanken and NBP – in that situation would ease monetary policy and as a result you would get relative inflation – domestic prices would increase relative to import prices and that is where you get bubbles in the property markets. Under NGDP level targeting the central bank would not ease monetary policy in response to a positive supply shock and inflation would drop ease, but the NGDP level would on the other hand remain on track.

However, the response to a demand shock – for example a drop in money velocity – would be symmetric under NGDP level targeting and inflation target. Both under IT and NGDP targeting the central bank would ease monetary policy. However, this is not what central banks that are concerned about “bubbles” are doing. They are trying to target more than one target. The first page in the macroeconomic textbook, however, tells you that you cannot have more policy targets than policy instruments. Hence, if you target a certain asset price – like property prices – it would mean that you effectively has abandoned your original target – in the case of Riksbanken and NBP that is the inflation target. So when governor Ingves express concern about asset bubbles he effective has said that he for now is not operating an inflation targeting regime. I am sure his colleague deputy governor Lars E. O. Svensson is making that argument to him right now.

I don’t deny that bubbles exist and I am not claiming that there is no bubbles in the Swedish, Polish or Chinese economies (I don’t know the answer to that question). However, I am arguing that monetary policy is a very bad instrument to “fight” bubbles. Monetary policy should not add to the risk of bubbles, but “bubble fighting” should not be the task of the central bank. The central bank should ensure nominal stability and let the market determine relative prices in the economy. Obviously other policies – such as tax policy or fiscal policy should not create moral hazard problems through implicit or explicit guarantees to “bubble makers”.

Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. I doubt that the Riksbank, NBP or the PBoC will make the same kind of mistakes, but bubbles have clearly led all three central banks to become overly cautious and as a result the Swedish, the Polish and the Chinese economy are now cooling too much.

I should stress that I do not suggest some kind of “fine tuning” policy, but rather I suggest that central banks should focus on one single policy target – and I prefer NGDP level targeting – and leave other issues to other policy makers. If central banks are concerned about bubbles they should convince politicians to implement policies that reduce moral hazard rather than trying to micromanage relative prices and then of course focus on a proper and forward looking monetary policy target like NGDP level targeting.

PS Note that I did not mention the interest rate fallacy, but I am sure Milton Friedman would have told governor Ingves about it.
PPS You can thank Scandinavian Airlines for this blog post – my flight from London to Copenhagen got cancelled so I needed to kill some time before my much later flight.

Related posts:

Boom, bust and bubbles
The luck of the ‘Scandies’
Four reasons why central bankers ignore Scott Sumner’s good advice

19 Comments
by Lars Christensen on October 22, 2012  •  Permalink
Posted in Bubbles, China, ECB, Federal Reserve, Lars E. O. Svensson, NGDP Targeting
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Posted by Lars Christensen on October 22, 2012

https://marketmonetarist.com/2012/10/22/dangerous-bubble-fears/

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

9 Comments
by Lars Christensen on October 6, 2012  •  Permalink
Posted in Bubbles, David Beckworth, George Selgin, Larry White, NGDP Targeting, Nominal Income Targeting, Scott Sumner, Steven Horwitz, The Great Moderation, The Great Recession
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Posted by Lars Christensen on October 6, 2012

https://marketmonetarist.com/2012/10/06/the-counterfactual-us-inflation-history-the-case-of-ngdp-targeting/

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

1 Comment
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Austrian economics, Bubbles, David Eagle, Deflation, Economic and monetary history, Emerging Markets, Exchange rate policy, George Selgin, Hayek, Inflation, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Robert Hetzel
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Posted by Lars Christensen on January 3, 2012

https://marketmonetarist.com/2012/01/03/ngdp-targeting-would-have-prevented-the-asian-crisis/

Chain of events in the boom-bust

In my recent post on “boom, bust and bubbles” I tried to sketch a monetary theory of bubbles. In this post I try to give an overview of what in my view seems to be the normal chain of events in boom-bust and in the formation of bubbles. This is not a theory, but rather what I consider to be some empirical regularities in the formation and bursting of bubbles – and the common policy mistakes made by central banks and governments.

Here is the story…

Chain of events in the boom-bust

– Positive supply shocks – often due to structural reforms that include supply side reforms and monetary stabilisation

– Supply side reforms leads to “supply deflation” – headline inflation drops both as a result of monetary stabiliisation and supply deflation. Real GDP growth picks up

– First policy mistake: The drop in headline inflation leads the central bank to ease monetary policy (in a fixed exchange rate regime this happens “automatically”)

– Relative inflation: Demand inflation increases sharply versus supply inflation – this is often is visible in for example sharply rising property prices and a “profit bubble”

– Investors jump on the good story – fears are dismissed often on the background of some implicit guarantees – moral hazard problems are visible

– More signs of trouble: The positive supply shock starts to ease off – headline inflation increases due to higher “supply inflation”

– Forward-looking investors start to worry about the boom turning into a bust when monetary policy will be tightened

– Second policy mistake: Cheerleading policy makers dismisses fears of boom-bust and as a result they get behind the curve on events to come and encourage investors to jump on the bandwagon

– In a fixed exchange rate the exit of worried investors effectively lead to a tightening of monetary conditions as the specie-flow mechanism sharply reduces the money supply

– The bubble bursts: Demand inflation drops sharply – this will often be mostly visible in a collapse in property prices

– The drop in demand inflation triggers financial distress – money velocity drops and triggers a further tightening of monetary conditions

– Third policy mistake: Policy makers realise that they made a mistake and now try to undo it “in hindsight” not realising that the setting has changed. Monetary conditions has already been tightened.

– Secondary deflation hits. Demand prices and NGDP drops below the pre-boom trend. Real GDP drops strongly, unemployment spikes

– Forth policy mistake: Monetary policy is kept tight – often because a fixed exchange rate regime is defended or because the central bank believes that monetary policy already is loose because interest rates are low

– A “forced” balance sheet recession takes place (it is NOT a Austrian style balance sheet recession…) – overly tight monetary policy forces investors and households through an unnecessary Fisherian debt-deflation

– Real GDP growth remains lackluster despite the initial financial distress easing. This is NOT due to an unavoidable deleveraging, but is a result of too tight monetary policy, but also because the positive supply shock that sat the entire process in motion has eased off.

-The country emerges from crisis when prices and wages have adjusted down or more likely when monetary policy finally is ease – for fixed exchange rate countries when the peg is given up

Leave a comment
by Lars Christensen on December 27, 2011  •  Permalink
Posted in Austrian economics, Banking crisis, Bubbles, General economic theory, MM Research agenda, Monetary policy, Moral Hazard, Uncategorized
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/chain-of-events-in-the-boom-bust/

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”

 

 



23 Comments
by Lars Christensen on December 27, 2011  •  Permalink
Posted in Austrian economics, Bubbles, Central and Eastern Europe, China, David Beckworth, David Eagle, Economic and monetary history, Emerging Markets, Exchange rate policy, Federal Reserve, General economic theory, George Selgin, Iceland, Inflation, Inflation Targeting, Luck, MM Research agenda, Monetary institutions, Moral Hazard, NGDP Targeting, Nominal Income Targeting, Quasi-Real Price Index, Robert Hetzel, The Great Recession
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/boom-bust-and-bubbles/

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