There Are Bubbles, and Then There Are Bubbles

Paul Krugman Conscience of a Liberal August 26, 2010

On the whole, I find it amazing and distressing that fear of new bubbles is playing such a large role in current policy discussion, leading too many prominent economists to recommend raising interest rates in the face of a hugely depressed economy. Even if you believe that excessively low policy rates were a key reason for the housing bubble — which I don’t — the idea that we should be raising rates now brings to mind the old joke about the motorist who runs over a pedestrian, then tries to fix the damage by backing up, and running over the pedestrian a second time.

Beyond that, I think we need to bear in mind that while bubbles are in general a bad thing, just how bad depends a lot on the context — in particular, whether the inflation of the bubble has been accompanied by a big increase in leverage on the part of those buying the inflated assets.

Consider the stock bubble of the late 1990s. It was crazy, and when it popped U.S. households suffered a capital loss of about $5 trillion. This was bad, and helped cause a recession. But it never rose to the level of economic catastrophe.

Then came the housing bubble, after which households suffered a capital loss of about $8 billion trillion [hey, a few zeroes more or less ... ]. Yes, they also suffered a big loss as stocks plunged — but that was because the housing bust, unlike the stock bust, had a huge impact on the financial system and the economy as a whole.

What was the difference? First, a lot of financial institutions — which are highly leveraged — were holding securities whose value was highly sensitive to the state of the housing market. There was nothing comparable in the case of stocks. So the housing bust undermined the financial system in a way the stock bust never did.

Second, households also leveraged themselves up in the housing boom, in a way they for the most part didn’t with stocks (yes, there were people buying dotcoms on margin, but they were not typical). So the housing bust created a balance-sheet crisis for the household sector in a way that the dotcom bust didn’t.

The moral for right now is that even if you believe that there are bubbles inflating or about to inflate, they’re only a big concern if they are leading to leveraged positions for key players. The alleged carry trade bubble sorta kinda mighta have met that criterion, although I never found the warnings all that persuasive. But other stuff — bubbles in BRIC equities, or gold, or whatever, don’t make the grade.

Anyway, my point is not so much about current events as a more general observation: the bubbles we should fear are those that lead to leverage, and set us up for a Minsky moment.

Paul Krugman is an Op-Ed columnist for The New York Times.

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About those inflation expectations.

August 26

Hey, What About Trenton?

I demand that my state capital be given its rightful place.

August 26 //

We’re Still In A Paradox Of Thrift World

Higher saving actually reduces investment.

August 25 //

Nick Rowe Loses It

When new monetarists attack.

August 25 //

Fire Alan Simpson

How far does IOKIYAR go?

From the Opinion Blogs Freakonomics When a Changing Labor Market Changes Business

Dot Earth A Challenge to Bill Gates on Energy Research

An energy and development specialist says mass deployment of non-polluting energy technology beats a focus on research.

I demand that my state capital be given its rightful place.

August 26

We’re Still In A Paradox Of Thrift World

Higher saving actually reduces investment.

August 25 //

Nick Rowe Loses It

When new monetarists attack.

August 25 //

Fire Alan Simpson

How far does IOKIYAR go?

From the Opinion Blogs Freakonomics When a Changing Labor Market Changes Business

Dot Earth A Challenge to Bill Gates on Energy Research

An energy and development specialist says mass deployment of non-polluting energy technology beats a focus on research.

Higher saving actually reduces investment.

August 25

Nick Rowe Loses It

When new monetarists attack.

August 25 //

Fire Alan Simpson

How far does IOKIYAR go?

From the Opinion Blogs Freakonomics When a Changing Labor Market Changes Business

Dot Earth A Challenge to Bill Gates on Energy Research

An energy and development specialist says mass deployment of non-polluting energy technology beats a focus on research.

When new monetarists attack.

August 25

Fire Alan Simpson

How far does IOKIYAR go?

From the Opinion Blogs Freakonomics When a Changing Labor Market Changes Business

Dot Earth A Challenge to Bill Gates on Energy Research

An energy and development specialist says mass deployment of non-polluting energy technology beats a focus on research.

How far does IOKIYAR go?

An energy and development specialist says mass deployment of non-polluting energy technology beats a focus on research.

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There Are Bubbles, and Then There Are Bubbles

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