Bubble and squeak -Further thoughts on America’s bubble economy THREE weeks ago (see article), The Economist suggested that America is experiencing an asset-price bubble. The thought has provoked both debate and abuse. Now, the “B-word” itself risks falling victim to speculative excess. Over those three weeks Wall Street has fallen, then rebounded to a new high as fresh data appeared to show that America’s economic miracle remains intact, then slipped again. Does this mean that we were wrong? Sorry to keep spoiling the fun, but no.

Our previous leader contained two arguments. First, that the explosion in share prices, the wave of mergers, rapid rises in property prices and an acceleration in monetary growth are all classic symptoms of a bubble, and the longer it inflates the more damage it will cause once it pops. Second, that the Federal Reserve should raise interest rates to let some air out of the bubble before asset inflation feeds through into consumer prices and does more damage.

In response, critics have claimed that share prices are not overvalued. It is true that some part of the rise in share prices reflects better economic fundamentals, but there is no room for doubt that on standard, time-tested valuation measures, prices are way out of line. Only on the view that the old indicators no longer apply can you argue that the market is fairly valued. No one can be sure that the world has not suddenly changed. But to say that it has is to make a helluva bet—one that most people would be wise to make only with someone else’s money. Some argue that the market is much more transparent than was Japan’s in the late 1980s and therefore less prone than Tokyo was to a financial bubble. Yet many of the “new economy” factors said to be justifying higher Wall Street valuations—hopes that inflation is dead and that new technology is boosting growth—are far from transparent.
Others object, more reasonably, that America’s economy is in sound shape: with no sign of inflation, there are no grounds for the Fed to act. It is true that recent economic data have been surprisingly good. In the first quarter of this year, GDP grew at an annual rate of 4.2%, inflation fell to its lowest level for 34 years, and the rate of increase in labour costs slowed. Wall Street soared as fears of a rise in interest rates eased. Yet the Fed would still be wrong to relax.

Look closer at the first-quarter figures and they are not quite so rosy as they appear. With the economy close to full capacity and frequent reports of labour shortages, the risk of higher inflation remains real. Domestic demand grew by an annual rate of almost 6% in the first quarter. Moreover, although the growth in the total employment-cost index (ECI) fell, wages and salaries in the private sector have accelerated in the past year. There is good reason to suspect that the ECI is understating the upward pressure on labour costs. Thanks to a booming stockmarket, firms have been able to reduce their contributions to pension plans, thereby holding down employee benefit costs. The growth in stock options has also helped to restrain wages. This virtuous circle could quickly turn vicious. Add in the fact that broad monetary growth has been accelerating, and there may already be a case to raise interest rates now to prevent inflation rising, even if the bubble in equity prices is ignored.

But a more important argument is that, even if consumer-price inflation remains subdued, roaring equity prices can still be harmful. The immediate, and for the Fed most relevant, danger is that asset inflation could feed through into broader goods and services markets. Nagging in its mind must also be the impact on financial and economic stability of a later and far bigger crash in asset prices. But there is already a strong case for the Fed to take account of asset prices in setting monetary policy (see article).

An unenviable task

This is not to underestimate the difficulties that the Fed faces. It is hard to decide how much to raise interest rates to check asset-price inflation. In the absence of rising consumer-price inflation, it is also likely to be politically unpopular, especially if it works. Investors, home-owners, bankers and politicians like the bubble economy: it makes them feel better off. They do not want higher interest rates, and they certainly do not want lower share prices, and they will certainly expect the Fed to slash rates if share prices collapse.

As the Fed’s chairman, Alan Greenspan thus has one of the world’s toughest jobs. Even so, the lesson from all previous bubbles bears frequent repetition: the longer asset prices continue to bubble, the louder the eventual bang.