Doesn’t the Great Moderation deserve some blame for the wave of asset-price bubbles?
Paul Krugman blames the wave of deregulation for the succession of speculative bubbles since the 1980s.
Now of course Krugman forgotten more macro than I ever thought about learning, so take this as an amateur suggestion awaiting vetting by professionals. But it seems to me that something else happened in the 1980s: the Great Moderation. Once we emerged from the Volcker interest-rate shock, we had a very long run of relatively low macroeconomic volatility.
If the threat of recession-linked declines in asset prices put a brake on speculation, and if that threat receded, then you’d expect speculation to get more … bubbly, wouldn’t you?
That doesn’t man deregulation, or a dozen other factors, weren’t also in the mix. But if market participants are confident that macroeconomic managers can prevent recessions, they why shouldn’t they bid the prices of assets that lose value when the economy tanks?
Author: Mark Kleiman
Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out.
Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken)
When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist
Against Excess: Drug Policy for Results (Basic, 1993)
Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989)
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14 thoughts on “Macro-economic management and bubbles”
I guess the problem with your hypothesis is the absence of bubbles during (to adapt The Onion) Â¨the long national nightmare of Keynesian prosperityÂ¨ roughly from 1945 to 1970. Since the previous era of prosperity in the 1920s was marked by a great speculative bubble, it does look as if the difference is regulation.
That period looks balmy in retrospect, but there were recessions in 1949, 1953, 1958, 1960, and 1969-70. Call it six in the 24 years following the recovery from the post WWII bust in 1946. In the 24 years from the end of the 1981-82 recession through 2006, there were two: 1990-91 and 2001. Neither was as bad as the average slump of the 1946-70 period.
Trade cycles (driven by overinvestment by real-economy businesses in equipment and stocks) or true speculative bubbles? Where were the crashes?
My point is not that asset prices crashed because of bubbles. They didn’t. It’s that asset price fell because of business-cycle effects. That was a risk of owning real estate and stocks. In the later period, the business-cycle risk diminished, leading – I hypothesize – to an unsustainable bidding-up of asset prices.
According to Krugman, most of these recessions were Fed-caused. The Fed raised interest rates, which triggered a recession, then they lowered them, which put us into recovery (note – I’m not assuming perfect, or even good, control of the system, just enough to kick it up or down).
He described the Great Financial Collapse as ‘Not your father’s recession, but your great-grandfather’s’, meaning caused by a financial collapse.
I’ve seen an analysis of the 1990-91 recession pointing out the same thing, which explains the long, slow painful job recovery from that (combined with the ‘peace dividend’, whose immediate effects were negative, due to a reduction in military keynesianism).
Mark, I think what you’d see in the details of those various “slumps” or “recessions” was reflective of the differences between “bubbles” and the more normal “economic cycle.” (See also, below, my reply to Brett in re “bubbles.”)
Because economic equilibrium is by nature unstable, the existence of cycles is inevitable. They represent the fact that employment follows (to some degree) production, which follows (to some degree) demand, which follows (to some degree) aggregate wages, which follow (to some degree) employment. Slight perturbations can destabilize a seemingly neutral equilibrium, beginning a cycle. Then, if left unchecked by the damping effect of government intervention, the “economic cycle” can become the “economic death spiral” and a cyclic adjustment can become a depression.
A “bubble,” OTOH, occurs because of an adjustment in the unstable equilibrium in asset pricing (ref. housing bubble, dot.com bubble, etc.). One could reasonably hope that such a bubble bursting could affect the plutocracy who make large sums betting on asset prices, but could leave the rest of us mostly unscathed. Sadly, there is enough correlation between asset prices and available cash for consumption spending that such a bursting bubble has an effect overflowing into the aggregate demand function, which then impacts the ordinary economic cycle.
Worst of all, though, when an asset pricing bubble bursts, one of the impacts is to cause bankers to “hunker down,” constricting credit, which has an immediate and disastrous effect on businesses having nothing to do with the asset class under attack. This, in turn, can turn a bubble bursting into a real recession, with dropping production, dropping employment, and dropping aggregate demand.
How do you separate a bubble from a genuine period of economic growth? They both end in recessions, and both involve drops in nominal GDP growth.
There is a substantial semantic difference between “bubble” and “growth.” And my rule is that semantics–the words we choose to use–are generally reflective of meaning, not simply cosmetic preference.
A “bubble” is a self-fulfilling process, a period of rising prices driven primarily by an expectation of rising prices, irrespective of growth in the underlying factors that comprise “value.” In the case of stocks, representing corporate equity, the principle is most starkly apparent. Warren Buffett prefers to buy stock in companies that have sound fundamentals and a likely prospect of real growth in production, sales, and earnings. He assumes that the price of the stock of such companies will likely track the underlying value of the fundamentals.
In a “bubble,” OTOH, the stocks are simply pieces of paper with a market price. The underlying assumption of speculators is that stocks will go up because that’s what they’re doing–going up. With such an outlook, it makes perfect sense to use your maximum leverage to make maximum possible profit on leveraged money. For example, think of the times you heard the “wisdom” of the day that it was foolish to pay down your home mortgage, when you could be using that available capital to buy more stocks and make a return far greater than the interest cost on your mortgage.
This “bubble” expectation, far more than any other fundamental reason like creditworthiness, was the major cause of the real estate “bubble,” followed closely by the “bursting of the bubble.” At the peak of the real estate bubble, there was a large excess inventory of homes–both second (and third) vacation homes for owners who could afford them, as well as speculative home purchases by “investors” who didn’t even worry too much about whether they could rent them, because the carrying cost (interest and taxes) was less than the expected increase in market price. so rental income could be treated as “found money,” rather than a necessity to justify the investment. When the market price inflation slowed down a little, so that the carrying cost was seen as a net cost, those same homes became unsellable at the presumed inflated prices, and the market “crashed.”
That’s a “bubble.”
Booms are about actual economic activity. Bubbles are about asset prices. Tulips, South Sea Company shares, the stock market in 1929, pets.com, and mid-2000s real estate were all bubbles. 1961-69 and 1993-2000 were booms.
The key idea here sounds like the key insight of the late economist Hyman Minsky. Not that I have actually his work, of course, but I do get my economic wisdom from good on-line sources — starting with Paul Krugman himself. I am guessing that Krugman would say that it is for exactly the reason you cite that really good regulatory schemes should have been maintained, rather than weakened.
As clarified MarkÂ´s Minskyish argument looks very plausible. However, it does clash with some of the beahviour of Wall Street post-disaster. You would think that the reality of downside risk had been reintegrated into their pattern of behaviour. In some respects, yes: they prefer to lend for nothing to the Treasury than to small businesses. But why have they lobbied so hard against prudential regulation of derivatives, high leverage and the like? Â¨The burnt FoolÂ´s bandaged finger / Goes wabbling back to the fire.Â¨
Many if the people in the banking industry were bailed out. That may have been necessary to save the economy, though I’m unsure. But in any case they weren’t burned so it isn’t surprising they haven’t integrated the downside risk.
In addition, whose fingers are burnt? If I had several great years (with bonuses to match) as a trader or manager in a financial firm, the crash at the end might be worth it, since the losses are incurred by others.
1987, anyone? the 1992 recession that ostensibly cost George Bush his re-election? The 1998 asian debacle? The dotcom crash? I think that an alternate explanation might be more that — due to deregulation and underfunding of regulators (who need to co-evolve with the regulated if they’re going to do any good) the ability of the finance people to screw up the economy finally exceeded the ability of the central-banking side to save them from their own stupidity.
I think that it may also be time to invoke a more specialized version of Niven’s Law: the bigger the shadow-banking sector gets before things go south, the harder it is to fix the results.
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