Greenie Is Still Bubble Blind
August 29, 2004
"But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy." ("The Challenge of Central Banking in a Democratic Society" - Remarks by Chairman Alan Greenspan At the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C. - December 5, 1996)
When Greenie uttered that infamous phrase the market showed its immediate disapproval with a swift drop in the NASDAQ (the most bubblicious of the indices) of 3% or so before recovering most of the losses by day's end. The market even went ahead on to get more and more "irrational" for more than three years after that day. Yet, that bitter one-day reaction apparently has been enough to chastise Greenie from ever again even suggesting that any bubbles might exist anywhere in our economy or financial markets. And who can blame him? Poor Greenie was really only posing a question that he obviously did not answer directly (surprise, surprise), and I am sure he meant well by it all.
In fact, it took about two whole years after the bubble popped in the U.S. stock market for Greenie to finally feel safe looking back and pondering just what a bubble looks like and what it means. These words are very instructive for anyone studying "bubblology." Poor befuddle Greenie essentially insists that it might be impossible to identify a bubble as it is blowing up…:
"Certainly, lurking in the background of any evaluation of deflation risks is the concern that those forces could be unleashed by a bursting bubble in asset prices. This connection, real or speculative, raises some interesting questions about the most effective approach to the conduct of monetary policy. If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt.
It may be useful, as a first step, to consider both the economic circumstances most likely to impede the development of bubbles and the circumstances most conducive to their formation. Destabilizing macroeconomic policies and poor economic performance are not likely to provide fertile ground for the optimism that usually accompanies surging asset prices.
Ironically, low inflation, economic stability, and low risk premiums may provide tinder for asset price speculation that could be sparked should technological innovations open up new opportunities for profitable investment. Even in such circumstances, bubble pricing is likely to be inhibited for a company with a history. To be sure, the stock prices of old-line companies do rise somewhat through arbitrage when the market as a whole is propelled higher by stock prices of cutting-edge technologies. But it is difficult to imagine stock prices of most well-established and seasoned old-line companies surging to wholly unsustainable heights. With some prominent exceptions, their capabilities for future profits have been largely tested and delimited.
The situation is likely different in the case of a new company that employs an innovative technology. Under these circumstances, the dispersion of rationally imagined possible future outcomes could be wide. If forecasts are unfettered by a need for consistency with the past, investors might take off on unwarranted flights of optimism. Moreover, skeptics find it too expensive or too risky to short sell the shares of such a company, especially when its stock price is rising rapidly.
The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient time to erode the traumatic memories of earlier post-bubble experiences." ("Issues for Monetary Policy" - Remarks by Chairman Alan Greenspan - Before the Economic Club of New York, New York City - December 19, 2002)
Wow! Heady stuff, eh? Not only are bubbles hard to see even when they are consuming all the air around them, but Greenie also suggests that only the most speculative of stocks can conceivably blow up to irrational proportions. Hmmm….let's see, Microsoft peaked at $58 (adjusted for splits) and is now languishing under $28 almost five years later. General Electric peaked right under $57 and is now making a valiant effort drifting back up to $33 or so about four years later. You can find plenty of examples to contradict the good Chairman's musings on this score. Greenie defenders might counter that these price drops were more the result of weakening economic conditions and not the popping of an overblown bubble. I would kindly ask for ONE example of an economy that suffered a bubble-popping with no subsequent adverse economic consequences. Blaming the economy for the pop ends up being circular - the only reason that a bubble exists for popping is that the economy cannot support the irrational pricing mechanisms spinning out of control! Anyway, note that despite Greenie's comfort with using the word "bubble," he still professes a kind of blindness to them.
Now, nearly everyone is familiar with the on-going debate about whether the world is now experiencing various bubbles in real-estate. Greenspan has been steadfast in applying his blindness to stock market bubbles to the red-hot real estate markets. First this quote from 2003:
"To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time." (Testimony of Chairman Alan Greenspan - Federal Reserve Board's semiannual monetary policy report to the Congress - Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate - February 11, 2003)
Pretty cogent analysis, right? Everyone ready to breathe a sigh of relief that the housing market in the U.S. is in no danger whatsoever, right? Greenie has the tools and the brainpower to keep all this under close watch with discerning eyes sharp as an eagle! Well, let us take a look at what Greenie most recently said about the alleged housing bubble!
" 'Taking a firm stand on the appropriateness of real estate prices is not possible,' due to data limitations, Greenspan said in written answers Tuesday to questions submitted by Senate Banking Chairman Richard Shelby, R.-Ala., in conjunction with Greenspan's report to Congress on monetary policy July 20. A Fed report to Congress on economic developments in the last six months noted that house price increases have outstripped income as well as rents in recent years. 'This observation raises the possibility that real estate prices, at least in some markets, could be out of alignment with fundamentals, but that conclusion ... cannot be reached with any confidence,' Greenspan said. He said the rise in house prices has been influenced by the low level of mortgage interest rates 'in ways that can't be gauged precisely.' 'Moreover, the available data are not fully adequate for a complete analysis of the issue; house prices are difficult to measure given the enormous heterogeneity of the U.S. housing stock -- both within and across geographic regions -- and available measures of residential trends do not match precisely with the units for which we have prices,' he said." ("Greenspan says housing data clouded: Can't judge if there are potential price bubbles" - By Gregory Robb, CBS Marketwatch.com, Last Update: 6:34 PM ET Aug. 24, 2004)
What?!? Now it turns out we have no reliable tools for identifying a bubble?! Sound familiar? Just as we were apparently helpless in the face of the stock market bubble of the late 90s, we now appear completely helpless in determining whether the housing market has gotten bubblicious or not. OK - my comfort just turned into awkward, squeamish, uh, horror! What will it take to get a diagnosis around here? Does an economy have to fall flat on its face again? Let's hope not. I sure hope note.
Even if poor, befuddled Greenie cannot identify bubbles growing in the garden, we can be sure of one thing. Americans are steadily getting poorer and poorer relative to their housing costs, especially in certain parts of the country. Sure, skyrocketing real estate is great for the sellers, especially when they can ply that same money into markets that have not grown as much as the one they left. But when it requires two and three and more people to comfortably afford just one home (even a starter home!!!) whereas in previous generations ONE spouse (for example) could buy the house and comfortably feed the family, we KNOW standards of living have taken a turn for the worse….regardless of where interest rates are now or then. I know of no better relative measure… Do you?