EconMatters, a commentator whom I respect, recently wrote that it is the Fed's responsibility to pop asset bubbles and gave the current state of the U.S. stock market as an example of a bubble that should be popped. I disagree, for three reasons. First, it is not possible to identify a bubble with any certainty. Second, if one identified a bubble, the Fed does not, in many cases, have the right tools or the right political position to take appropriate action. Third, the stock market is not the economy, and not all asset bubbles pose the same danger to the economy.
Asset bubbles can cause damage
But before I elaborate on those criticisms, let me say that I applaud EconMatters for pointing out the damage that a bursting bubble can cause to the economy and to the financial system. The bursting of the 2000s housing bubble caused great damage to the economy as a whole and to the financial system. The damage to lower- and middle-income Americans was especially severe. And therefore, preventing some kinds of asset bubbles from forming should be an important aspect of national economic policy.
Debt-fueled asset bubbles are the dangerous ones
Not all asset bubbles are created equal, however. It is only debt-fueled asset bubbles that cause general economic harm when they burst. And, for the most part, it is only real estate asset bubbles that have created general economic harm historically.
How many asset bubbles are there?
At the present time, we have a number of candidates for asset bubble status: the U.S. stock market, the dollar, U.S. sovereign securities, high yield bonds, and emerging market bonds, as well as, perhaps, U.S. house prices (nationally or regionally), U.S. commercial real estate prices (perhaps only in some classes of property), bonds of several European nations, Japanese sovereign bonds, Chinese real estate, Chinese currency, and Chinese corporate bonds. Which of those candidates is actually a bubble? I confess not to know.
Which of those candidates has the possibility to cause great damage to the U.S. economy may be more knowable, however. The Chinese bubbles are potentially important to the rest of the world, but it is difficult to know what the impact of a Chinese bubble bursting would be, since we should not impute normal market economic outcomes to China, even in the medium term. The bursting of the other foreign bubbles could have an impact on international trade, but would have no more direct impact on the U.S. I reject them as serious U.S. problems.
How dangerous are stock market bubbles?
Regarding the U.S., we know something about stock bubbles and what happens when they burst, since we have two recent case histories in the bursting of the dotcom bubble and the stock market rout of 2007-2009, with the attendant significant differences in real estate prices contemporaneously. The dotcom bubble caused relatively little harm to the broader economy and none of significance to the financial system. That was because the stocks were, for the most part, bought with equity, not debt, and therefore, the losses fell mostly on people and institutions that could afford them, with no cascade effect from margin calls and the like.
The stock market crash of 2007-2009, by contrast, was an incidental event caused by the tanking of the real economy and the severe stresses on the financial system that caused panic conditions. Those who did not sell their stocks in late 2008 through early 2009 were duly rewarded when stocks regained their previous levels within a few years. It was the contemporaneous real estate bubble that wreaked havoc on the real economy through the cascading effects of defaults, foreclosures, job losses, and general economic decline. People lost their homes not because their value went down, but because they were highly leveraged.
The financial institutions that failed also failed because they were highly leveraged and because of the cascading effects that occur when highly leveraged institutions suffer losses and assets are written down to current market values.
My conclusion is that by themselves, stock market bubble-bursting events, absent a high level of debt-financed ownership, are not a cause for general economic alarm. People like me (probably you too) lose money. And perhaps our lifestyles get a little bit crimped for a while. But the effect on the broader economy is marginal.
I think we could say the same for the markets in high yield bonds and emerging market debt. Those markets are largely funded by equity, and the hedge funds and their ilk that are funded with debt are not large enough to have significant consequences economy-wide.
What about a dollar bubble?
A wild card would be a bubble in the dollar and U.S. sovereign debt. Suppose the value of the dollar began to decline significantly and interest rates on U.S. sovereign debt rose precipitously in response. That could well cause severe economic events that could impact both the real economy and the major financial institutions.
Thus, the bubbles I would worry about are (or might be) in the U.S. dollar and in U.S. real estate.
What to do about bubbles?
But what would I do about those worries? I still do not know whether there are bubbles in those assets. And if I concluded that there were, if I were the Fed, what would I do about them? Would I raise interest rates a quarter of a percent? Or would I raise them a full percentage point, thereby ensuring that the bubble will burst and that its consequences come to pass?
No, to be successful, I would have had to have acted before there was a bubble. But when would that have been? If a bubble is hard to identify, how would one expect to identify an incipient bubble?
The only solution that I can see is to focus on the credit side. If lending institutions adhere to sound credit policies, then credit will not fuel bubbles. Stress testing, for example, forces lending institutions to focus on credit quality and what happens to it in a recession.
Is that a realistic policy to promote when the president is a real estate man whose business life has confirmed the real estate adage that a dollar borrowed is a dollar earned? I dunno. But we may be about to find out.
If the government abandons any focus on lending institutions' credit quality, "Katie Bar The Door!" You ain't seen a bubble yet. It'll take a while to inflate, and most folks will cheer the boom that the bubble creates because they will make money. "But one of these days..." as the fictional Ralph Kramden used to say, "Pow, right in the kisser!"
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.