Let's Burst the 'Bubble' Theory


WSJ 98-05-14

When the economy is expanding, journalists eventually get bored. Their tedium inspires imaginative writing about invisible crises. Last year's favorite economic horror story was "deflation," but the threat of cheap oil and cheap computers wasn't ominous enough to sustain readers' attention. So journalists have pumped up a new scare: Instead of a deflating economy, we are said to be living in an inflated "bubble." Sensational comparisons are drawn with Japan in the late 1980s, or even the U.S. in 1929.

It started with "America's Bubble Economy," an April cover story in The Economist. Within days, the Financial Times had published an article called "Addressing the U.S. Bubble," and Japan's Daily Yomiuri had weighed in with "U.S. Economy Shows Signs of Bubble Blues." A Journal of Commerce editorial compared America's blue-chip stocks to 17th-century tulips: "It may be too late, but the Federal Reserve should dampen speculation that . . . tends to end in crisis." The following day, USA Today devoted a full page to "speculative bubbles . . . popping up here and there throughout the economy." Reporters were alarmed to discover that people were "speculating" on depreciating assets, such as yachts and Rolls-Royces.

Burst of Air

Rare dissents from the bubble notion have merely questioned the claim that U.S. stocks are grossly overvalued. This month, meanwhile, The Economist decided to give the bubble another burst of air, complaining that "the more intellectually challenging side of our argument has received little attention: should a central bank such as the Fed set monetary policy with an eye only to consumer prices, or should it, as we contend, worry about the prices of financial assets as well?"

How much attention does this "intellectually challenging" idea require? Three arguments lie behind the idea that the Fed should raise interest rates to depress prices of financial assets. First, there is a theory--that rising prices of financial assets are an omen of inflation. Second, some evidence is offered to show that "too much money chasing too few assets inflates asset prices." Third, there are historical comparisons, with Japan in 1987-89 and the U.S. in 1928-29.

When it comes to the theory, bubble poppers are quite selective, fretting about high stock prices rather than high bond prices. It would be preposterous to suggest the Fed should worry that low or falling bond yields are an omen of future inflation. Yet it is no less preposterous to worry that low or falling equity yields (i.e., rising stock multiples) are an omen of inflation. Bond prices have risen and yields fallen because actual and expected inflation has come way down. Stock prices have also risen and equity yields fallen for precisely the same reason. Regardless of whether "financial assets" means bonds or stocks, only a resumption of high inflation would truly pop the "bubble."

What about the evidence? Bubble theorists agree that the problem is too much money, but not on how to measure money, or where it came from. To The Economist, "the most damning evidence of a bubble is America's rampant monetary growth." To the Financial Times, "the most compelling evidence of a bubble comes from the recent expansion of the Bank of Japan's balance sheet." USA Today echoes the latter view, claiming that "much of the money [causing 'speculative bubbles' in the U.S.] is coming from Japan, where the central bank is pumping out trillions of yen." Rising stocks in the U.S. are proof of "rampant monetary growth," while falling stocks in Japan also prove the Bank of Japan is following, as The Economist put it, a "super-loose monetary policy." Got that?

This argument works by switching from the broadest measure of money (M3) for the U.S. to the narrowest measure (M1) for Japan. If the U.S. were judged by the same standard used to claim that the Bank of Japan has a "lax" monetary policy, the Fed would be found guilty of tight money. Growth of the U.S. monetary base has accelerated only modestly, to 6% from about 2.5% over the past three years, and has dropped below zero since February. Conversely, if Japan were judged by the same broad-money standard used to claim the U.S. has "rampant monetary growth," then the Bank of Japan looks tight-fisted. Growth of M2 plus certificates of deposit in Japan has been only 4.5% over the past year.

For the U.S., bubblists assume that simultaneous increases in M3 and stock prices must prove that M3 pushed stocks up. But M3 includes professionally managed money--institutional money market funds and jumbo CDs--which is why it has grown much faster than M2. The claim that M3 has been pushing stocks up implies that money managers have been surprised to find too much money sitting in their money market accounts and CDs, so that they bid up stock prices to get unsuspecting sellers of stocks to accept the unwanted cash. There is a far less fanciful explanation: With stock prices up, big traders have to keep bigger cash balances to finance the larger dollar volume of transactions.

In reality, bubble theorists use M3 as a handy excuse, not as a policy target for the Fed. If short-term interest rates were increased, that might even encourage portfolio managers to hold larger amounts of interest-earning assets, thus boosting M3. But faster M3 growth would not trouble the bubble theorists. All they really care about is raising interest rates and lowering the value of stocks and bonds. Wouldn't that increase the risk of recession? Not to worry, they say, since the Fed can then lower interest rates. First put the rates up to drive down the markets, then put them back down once the damage is done. Is this trip really necessary?

The policy lessons bubble theorists draw from their favorite bubbles are astonishingly perverse. From 1987 to 1989, the Bank of Japan bought enough securities to allow the monetary base to increase by 11.5% a year, and broad money by 10.9%. That may indeed have inflated the prices of land and of stocks of companies that owned real estate or made loans against it. But Japan's subsequent bubble-popping accomplishments do not make this look like an innocent sport.

Japan's discount rate was hiked to 6% in August 1990 and bank credit was rationed (partly because of Basel's dubious capital standards). In 1991-92, the monetary base was actually reduced by 2.8% a year, and growth of broad money slowed to 1.2%. Growth of nominal gross domestic product slowed to 2.8% in 1992 and to less than 1% a year from 1993 to 1995. How did this happen? The Bank of Japan (with help from the government, which imposed new taxes on land and stocks) did precisely what The Economist now advises the Fed to do. The deliberate deflation of asset values had spill-over effects on Japanese bank capital and loan collateral that have proven quite hard to fix.

What's more, unlike the Bank of Japan in 1987-89, the Fed certainly has not been inflating bank reserves and currency at double-digit rates. The bubble analogy is bogus, and bubble-popping advice could prove as dangerous as for the U.S. at it has for Japan.

Credit Expansion?

But what about the alleged 1929 bubble? "Seven decades ago," warns The Economist, "asset-price inflation was also associated with rapid credit expansion." Credit expansion? The bait has been switched again, from money to some undefined measure of "credit" in 1929. The motive for changing targets is again transparent: The U.S. monetary base declined in 1929 as the Fed sold securities; growth of broad money was zero after May 1928 and sharply negative after the crash the next year.

In their classic "Monetary History of the U.S.," Milton Friedman and Anna Schwartz note that "there is no doubt that desire to curb the stock market boom was a major if not dominating factor in Federal Reserve actions during 1928 and 1929." Between January 1928 and August 1929, the discount rate was increased four times, to 6% from 3.5%. The rate on call money hit 20%. With a lot of help from the Smoot-Hawley tariff (which imploded world trade), the Fed clearly set out to deflate U.S. stock prices in 1929. Modern bubble theorists' real complaint with what the Fed did in 1928-29 is that the Fed failed to act with greater alacrity and sadism.

In the seventh year of economic expansions (1969, 1989, 1998), comments about the economy often alternate between premature euphoria about a "new era" and extreme paranoia about imaginary future disasters. The bubble metaphor meets the familiar demand for bearish forecasts, so it will be with us for quite a while. Eventually, though, bubble hysteria is bound to become as tedious as such earlier sensationalism as deflation or 1989's "hard landing." Unless, of course, the Fed actually acts on this bubble bunk.

Mr. Reynolds is director of economic research at the Hudson Institute.