Bubbles Are Getting Blown Out of All Proportion

Op-ed in the Financial Times

September 8, 2004

Like the hellfire preachers of yesterday, today's economic pundits are taking a stern line on excess. Economies that enjoyed asset price booms, notably the United States, are damned to pay for their wanton ways. Central banks that attempted to offset the negative effects of a bubble's burst, notably the US Federal Reserve, are merely postponing the day of judgment and, if anything, compounding their sin by blowing up other bubbles-in housing, or in government bonds, or both. The financial press is full of grim prognostications of economic damnation postponed but not avoided.

This is all pernicious nonsense. Pernicious because it discourages central banks from responsibly doing their job of stabilizing the real economy, as the Fed correctly did in 2001-03. Nonsense because there is no evidence to support these claims. Bubbles have only rarely caused the lasting damage that these commentators assert as unavoidable destiny; when they have, it has been because central banks have failed to respond to the bubbles' aftermath. The outdated but apparently still widely attractive monetarist image of liquidity as toothpaste-if you squeeze the tube in one place, it bulges somewhere else-does not stand up empirically.

Consider the evidence. Researchers at the International Monetary Fund have come up with lists of 18 property and 24 equity booms in the main Organization for Economic Cooperation and Development economies since 1970. Working with these, one finds that bubbles are a lot less scary, and central bank activism far less to blame for them, than current discourse would lead one to expect.

Monetary ease is neither necessary nor sufficient to produce bubbles. There have been 48 periods of sustained monetary easing in the 15 main industrial countries since 1970, as measured by M3 growth or ultra-low real interest rates, and only 17 of them resulted in asset price booms. At the same time, only one-third of the booms identified by the IMF were preceded or accompanied by monetary ease. If one looks at ease as measured by interest rates, there are essentially no cases where booms were preceded or accompanied by monetary ease. Bubbles are made in financial markets, not in central banks.

Bubbles are rarely followed by either deflation or further bubbles. The dangerousness of bubbles is taken for granted. According to the received wisdom, either they put a lasting burden on investment and prices when they burst or, worse, they lead to follow-on bubbles that build up a bigger collapse. Yet fully three-quarters of the asset price booms had no follow-on bubbles after their busts, and fewer than one in 10 busts led to periods of consumer price deflation.

This cross-national evidence is consistent with economic historians' assessments of the US experience. Among the many booms, panics, and busts in the 19th and 20th centuries, only those accompanied by banking problems had negative consequences lasting beyond a few quarters. Bubbles can pop with limited macroeconomic impact, and usually do.

Central banks do no harm by stabilizing the economy post-bust. The bubbles and damnation set would have us believe that central banks either add to a bill coming due or sow the seeds of the next bubble by cutting interest rates to stimulate growth in a bubble's aftermath. On the first contention, if an economy is likely to grow at a rate below its potential and inflation expectations are low and stable-highly likely in the aftermath of an asset-price collapse-there is no economic justification for thinking that a stimulative monetary policy somehow creates a growth "debt" that has to be made up later. (Irresponsible fiscal stimulus can do that, but that is because it literally involves spending other people's money. This is especially the case if that money comes from abroad.)

As for the second contention, the moral hazard story of "the Greenspan put"-in which investors believe the Fed will step in to protect them if the market crashes, and so act recklessly-is a cute story, but that is all it is.

Investors do not decide whether or not to risk their money based on whether the central bank cut rates in the aftermath of the last bubble. In fact the evidence is that, if anything, investors have less risk tolerance for extended periods after bubbles, whether or not the central bank cuts rates. Only two of the 15 big industrial economies (Finland and Italy) have had recurring bubbles since 1970-all the rest had to wait through a long period of fading memories and turnover in financial services personnel before a second asset price boom emerged (if one ever did).

Japan's experience of boom and bust is a case in point. The property and stock market booms of the 1980s began three years before the Bank of Japan eased policy more than its standard reaction to economic conditions would have justified, and ended shortly before those policy moves had had their full effect. The pattern during the boom of who bought what securities and lent to whom was clearly driven by the incentives of partial financial liberalization, not by aggregate interest rates.

Deflation did not emerge in Japan until the end of 1997, many years after the bubble had burst. It was a consequence of years of failure by the Bank of Japan to respond adequately to slowing growth, the Ministry of Finance's decision to raise taxes in a recession and the corporate sector's inability to face up to bad loans, a problem that was allowed to grow to vast proportions. After the bubble burst, the BoJ's unwillingness to stimulate the economy unless government and business "got the rot out" served only to encourage more wasteful government spending, greater declines in corporate and bank capital and constant renewal of bad loans.

Thankfully, the Fed, as its aggressive rate cuts in 2001-03 show, has learnt these lessons. The monetary moralists preaching inevitable doom for the US economy because the Fed dared to stabilize the economy after the bubble's collapse are simply wrong. All reasonable people agree that today, with rising inflation, burgeoning Federal deficits and the possibility of a stagflationary oil shock, interest rates should be on an upward path in the United States. But the Fed is right to wait for the data to come in to determine the pace of that increase.

Nothing about the US economic outlook is written in stone, whatever the preachers say.