Buble & Bursts.
"Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic.
However, the penchant of humans for quirky, often irrational, behaviour gets in the way of this conclusion. A discontinuity in valuation judgement, often the cause or consequence of a building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets.I do not have much to add on
this issue except to reiterate our need to better understand it."
Chairman Alan Greenspan
Globalization and Innovation.
At the Conference on Bank Structure and Competition,
sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois
May 6, 2004
This article is a sneak preview of my upcoming Tract: Plea for a New World Economic Order.
This article deals with the mechanisms of the building and bursting of Asset Price Bubbles.
It shows that the building of bubbles is inherent to the Capitalist economy and is due to the increase of Income/Wealth disparities.
It shows that there are several ways by which Bubbles burst. The only one which is worrying from a macro economic point of view is due to the ominous Keynes' Liquidity Trap.
As we saw in the Chapter Greenspan Conundrum and Income Wealth Disparities, the return on marginal (new) investments goes down which means that the future cash flows of previous investments are actualized at a lower rate. Which explains why on the long-term the price of long-term assets (bonds, stocks, businesses or real estates) goes up (if the risk premium is stable or goes down). There is nothing irrational (Alan Greenspan) or speculative (John Maynard Keynes) in that, it is the logical result of market forces. Bubbles are an inherent factor of the capitalist economy it is the result of the confrontation of supply for savings and demand for investments.
Bursts do Occur, Why?
There can be two reasons or an increase of long-term yields of Treasuries or an increase of the risk premia.
There is one obvious reason is when the monetary policy is too strict and cause short-term yields rates to go up too fast, the yield-curve becomes too inverted. The inverted yield curve is an unstable equilibrium. If that unstable equilibrium receives a shock, it causes a sudden transfer of allocation from long-term assets toward short-term assets, logical consequence of the maximization of present value by Market participants, and a discontinuity of present value (the 1987 crash due to the high interest rates inherited from the hawkish Paul Adolph Volker the man in charge of ObaMacroEconomics. People don't need to be hawks, dove, bulls or bear. It is enough if they tried to be humans. It is difficult enough as it stands.).
This kind of burst is quickly resolved by lowering short-term interest rates, which causes a change in Market preference between short-term and long-term assets (The Greenspan Put). That type of Crash occurs in general in a high interest rate environment.
The second type of burst occur when the market reassesses the risk and/or return of one class of assets and result only in a reallocation among long-term assets, which has no bearing on macro economy (dotcom burst). That kind of Crash occurs with any interest rate environment.
It is however often the case that the first two types of crash reinforce one another.
Those two bubbles are resolved on the short-term and do not have a lasting influence on GNP they don't constitute a systemic risk (endangering the whole system) per se. They must be of no concern for the FED. In those two cases the buy and hold strategy of a diversified portfolio stays the best option.
"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.
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."
Chairman Alan Greenspan
The Challenge of Central Banking in a Democratic Society
At the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research,
December 5, 1996
The third type of burst is more worrisome: it occurs in a Liquidity Trap. When prices of assets go down in general it means that their yield go up. But in a Liquidity Trap the revenue of the investment goes down briskly because there is no money supply. The return on investments stays below the rate of the Liquidity Trap and never meets the offer: the yields of investments go down with their price because the demand dwindles even faster than the price of assets - (in order to restore the demand you need to restore investments for which you need to restore demand: a perfect catch 22). In order to get out of the Liquidity Trap you need a drastic New Deal, a new repartition of wealth and incomes. In a capitalist economy the only way that can be restored is by the physical destruction of productive assets through rust or war. That can take an excessively long time or be extremely deadly: Keynes' Fiscal Stimulus did increase demand but didn't get the economy out of the Liquidity Trap. What did get the economy out of it was WWII. See the upcoming chapter: Economic Policy in a Depression.
"But this long run is a misleading guide to current affairs. In the long run we are all dead.
Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."
John Maynard Keynes
A Tract on Monetary Reform
(1923) Ch. 3
That last burst occurs in low interest rate environment.
The buy and hold strategy with a diversified portfolio is the best one on normal times. It will end with catastrophic results in a Liquidity Trap.
The Present Economic Crisis:
The reason the Sub Prime chaos occurred was that it has accumulated the two causes of a Market Crash. The reassessment of two classes of long-term assets: the real estate and the MBS, an inverted yield curve. The reassessment of the value of MBS and real estate came when people stopped repaying their mortgage (which was partly due to the high short-term interest for those who were locked in variable rate mortgages. Note that the reason why they were offered these variable rate mortgages was that the yield curve was inverted and it was hence more profitable for the banks to lend short-term rather than long-term.) This caused a reallocation of savings that gave a shock to the yield curve (at that time MBS was prevalent as the only "worthwhile" long-term investment) so not only people disengaged from real estate and MBS but also they did reallocate from long-term assets to short-term liquidities. The FED had to lower very fast their short-term rate and make the yield curve normal or steep.
The long-term yields went down to the point where they went below the yield curve of Keynes Liquidity Trap.
But the true cause was that it was a flight to quality not a brisk decrease of the return on investments: the break down of credit market was due to an increase in the perception of risk by the lenders.
I made the mistake, as many others (I was in good company: Alan Greenspan, Nuriel Roubini, the Famous editorialist Krugman, and even Benjamin Shalom Bernanke who thinks he has overcome the Liquidity Trap.) to believe that the present crisis was due to a Liquidity Trap.
There was several elements that were lacking to qualify as a Liquidity Trap ("When facts change, I change my mind, what do you do sir?")
I - A gradual lowering of long-term interest rates: the lower interest rates are the cause of the crisis not as it was the case the consequence.
II - The crash will have to be sudden: the crash was slow, a large correction, but we never saw the Market fall by more than 15% in one day. It will have to happen at an extremely high point for the stock market: it occurs a minimum of long-term interest rates! Minutes before the crash occurs people will be at the highest of their optimism about the future of the economy.
III - The corporations must be unwilling to borrow because of their low expected rate of return.
IV - There is no monetary or fiscal policy to get out of a Liquidity Trap (cf Part III)
We are not yet in the ominous Keynes' Liquidity Trap (See the chapter Are we in the Keynes' Liquidity Trap, Yet?) When we will be the Market will behave in a Chaotic manner you have never seen before.
The economic consequences will be disastrous.
Extreme Economic Conditions Call for Radical Solutions.
The Controversial Innovation Since John Maynard Keynes and Milton Friedman.
The Yield Curve - The Plausible Alternative.