If There Are Bubbles, It's Better to Pop Them
If you go back 20 or 25 years, the term "bubble" was not part of everyday language. To be sure, scholars debated various financial bubbles. Most famous was the stock market bubble of 1929. Before that, there was the South Sea bubble of 1720 in England. And before that, there was the Dutch tulip bubble of the 1630s. But most Americans were blissfully ignorant of these episodes. Hardly anyone imagined bubbles as a modern problem.
Now the pendulum has swung to the opposite extreme. Almost any powerful phenomenon that is deemed unsustainable qualifies as a "bubble." Is there a "college bubble," suggesting that there are more college graduates than jobs for college graduates? Or is the tea party a "bubble," implying that its power was exaggerated and is waning? Still, bubbles' notoriety - as a term and concept - remains grounded in the economic and financial world.
Generally, these bubbles signify a situation when some prices (say, of stocks or houses) get dramatically disconnected from their underlying economic foundations (in these cases, corporate profits or family incomes). Prices may temporarily rise on the self-fulfilling expectation that they will increase. Herd psychology rules. But sooner or later, the disconnect becomes too great. The bubble "pops." Prices collapse.
We're told by various authorities that we may face multiple bubbles. The housing bubble is said to be returning or has already returned. Since their low point in March 2012, home prices are up 23 percent, according to the S&P/Case-Shiller index. Another alleged danger is a bubble in "tech stocks," with prices grossly overvalued. Facebook's price-earnings ratio (P/E, the ratio of a stock's price compared with its per-share earnings, or profits) is near 80, according to Yahoo Finance. LinkedIn's exceeds 650. By contrast, stocks' average historical P/E is close to 15. We're also warned of possible bubbles in bonds, farmland and corporate takeovers.
Globally, China is struggling with a credit and housing bubble. Canada may face a housing bubble, says Alex Pollock of the American Enterprise Institute. Its run-up of house prices since 2000 (132 percent) actually exceeds the peak U.S. increase (90 percent in mid-2006), he says.
"Bubble" is no longer a neutral word. Given its association with the financial crisis, it is pejorative. It suggests impending doom. Popped bubbles are to be feared. That's the conventional wisdom, and it is overkill.
In advanced economies with reasonably free markets, bubbles are unavoidable. Some asset prices will always get too high. This will reflect miscalculation, greed or John Maynard Keynes's "animal spirits." The popping of these bubbles is, on the whole, a good thing. It restores a sense of proportion and reminds people to be more careful in their decisions. Markets go down as well as up. This learning is an important, if distasteful, discipline.
It cannot be performed exclusively by regulation. Regulators, like the people and institutions they regulate, have blind spots. Most missed the housing bubble. It's always easier to identify a bubble after it has burst than while it's inflating. The evidence often confounds. Today's national home prices, for example, are up from their lows but are still 20 percent below earlier peaks.
Nor do most popped bubbles cause economic calamity. They impose losses and hardship, but more often than not, these are limited. Even the effects of the most damaging bubbles can be exaggerated. The 1929 stock market crash did not cause the Great Depression. The government's too-passive response, turning what would have been a conventional downturn into a tragedy, was the main culprit. From 1929 to 1933, the government permitted 40 percent of U.S. banks to fail.
Similarly, it was not simply the bursting of the housing bubble that created the Great Recession. Consider the contrast between the 1990s' tech-stock bubble and the housing bubble. Both inflicted multitrillion-dollar losses. Yet the first caused only a mild recession while the second plunged the economy into a deep and stubborn slump. Why?
The difference is this: The housing bubble spawned a broader financial panic; the tech bubble didn't. No one knew which banks held "toxic" mortgage securities and which didn't. Large deposits fled banks, which in turn reduced lending (banks' loans fell nearly $600 billion in 2009). Borrowers cut their expenses. Firms laid off workers; consumers curbed spending. It was the panic that did the most damage.
Having ignored bubbles for decades, we now see them around every corner. For more than five years, the Federal Reserve has tried to revive the economy with low interest rates. One danger of this strategy is that the cheap credit will inflate financial bubbles rather than promote spending and production. This is the crux of today's worries about bubbles, whose existence and magnitude are - at this point - unclear. If there are bubbles out there, the sooner they pop the better.
