December 9, 2008
Some people say there are no “bubbles.” I disagree with that. I think there have been situations that were called a bubble, but really weren’t. I don’t see any particularly bubbly behavior in 1929, for example. Exuberant, as befits a time of such dramatic economic expansion, but not bubbly. I think there was some bubbly behavior in Japan in the late 1980s, but not nearly as much as most people think. The dot.com and housing/credit events in 2000 and 2007 in the U.S. qualify as bubbles, in my opinion.
Alan Greenspan had a policy of not trying to spot bubbles before they happen, but perhaps to deal with the effects afterwards. He has come under criticism for this, but in the broad, I agree with it. It is useful from a political standpoint. On the way up, practically by definition, the majority of people don’t think there’s a bubble (just think of all the “housing only goes up” types in 2005, the buyers of CDOs, or the private equity daredevils), and certainly they don’t want anyone to stop the party. On the way down, after everybody finally gets it, then the Fed has more of a political mandate to do something. Also, the Do Something that the Fed does at that point is typically some sort of “easing,” which is to say, a politically welcome event.
So, we have two problems to begin with. First, it is not so easy to spot a bubble, since a bubble is, practically by definition, a sort of mass hysteria. Of course they are very obvious, but the bubble-spotters are always a lonely minority. Just look at the crap that Peter Schiff took in 2006 and 2007 — when the housing bubble had already popped! Also, there is the possibility that one could spot a supposed “bubble,” and basically be wrong. Just think of everyone who thought $40 oil was a “bubble” in 2004. (I think oil will be headed up again.) Or, everyone who thought that U.S. stocks were in a bubble in 1986. Second, there is the political issue. Nobody wants someone like the Fed to step up and end the party, especially when it holds opinions that are in the minority (as they always are at that point).
To that we add a third problem, which is: the acts taken to “break the bubble” are often worse than if the bubble had busted naturally. This might sound like heresy, but what is a government actually supposed to do to break a supposed bubble? The typical responses are: higher interest rate targets, and higher taxes. This, in fact, is precisely what the Japanese government did in the 1989-1994 period, specifically and overtly to break the supposed bubble in property. Guess what — it worked! The situation ended up being much, much worse than if the property market had simply deflated on its own. I documented some of the many tax hikes on property in my book. It would be fun sometime to do a more detailed study of this period. (PhD types — there’s a nice thesis for you. Send me the results.) Oddly enough, when things were really falling apart, the government did virtually nothing to fix the problems it had created, in its efforts to “pop the bubble.” Japan’s government was not the only one to do this — Korea did similar things a few years back, not to the same extent but the idea was the same. In other words, be very, very careful when getting the government involved, because the government, collectively, is intensely stupid.
There was also a “bubble” in Japanese property in the late 1950s, up to about 1963. Actually, in terms of price rise, this bull market was much larger than the bull market of the late 1980s, which is rather teeny by comparison. In 1960, for example, the urban property price index rose 68%! It powered up another 45% in 1961. (The largest gains of the late 1980s were about 28% per annum.) Eventually, a bear market set in, and property prices spent much of the middle 1960s grinding sideways, even though nominal GDP was growing 15%-25% per year. Here was a case in which the property market was simply left to work itself out, and guess what — nothing happened. The economy was fine. The fact that the Japanese government cut taxes every year during the 1960s, and kept the yen pegged to gold, didn’t exactly hurt.
Greenspan, I believe, is aware of the Japanese case.
Because of this, I recommend oversight rather than legislation per se as a way for the government to manage asset markets. The government simply puts an informal limit on LTVs, neg-ams, volumes of deals being done, or what have you. The government does not hike taxes or fool around with the blunt tool of monetary policy. Which means that the ball is out of Greenspan’s court. The Fed supposedly serves as a banking regulator, but the Fed isn’t a branch of the government (despite acting like one). So, that suggests it’s Treasury’s job. Certainly the removal of various limitations on banking activity and leverage (Glass-Steagall among others) contributed to the present situation. Did the Fed repeal Glass-Steagall? Or was it Congress? Hmmmm … don’t wait for any “I’m sorrys” from Congress.
This brings us to a fourth point, which is: the aftereffects of a bubble are often overstated. There are several economic events which have been blamed on a supposed “deflating bubble,” but were primarily due to other causes. The Great Depression, for example, is still conceived by a great many as a sort of “spiral of doom” touched off by a falling stock market. Not so. Likewise with Japan, the real problems were dramatic tax hikes and historically unprecedented monetary deflation. The Asia Crisis was primarily a currency event. The present situation in the U.S. actually is, mostly, the various effects of a financial bubble (despite some Peak Oilers’ claims otherwise). Whenever there is a major asset market decline — and there always is in any major economic event — it is very easy to point to that amazing price chart and say “see, it was a bubble!” We know it was a bubble, because it “busted,” i.e. it went down a lot. All the people who bought at $100 must have been stone nuts, because the stock was later at $10. Put in such simple terms, we can see this is grossly stupid, but if you pay attention I think you will sense this line of reasoning is quite common. The result is that the “bursting bubble” gets lots of blame, and the other, more important factors are largely ignored. The “bursting bubble” fills the need for an explanation, so people get lazy and they stop looking for the real reasons.
This means that it is not quite so important to prevent bubbles, because they are not so dangerous as they seem. The exception to this may be when there is lots of debt involved — which tends to mean property. If stocks go up and down, well, who cares really. But, if debt doesn’t get paid, there are consequences.
So, with all of this in mind, I tend to follow Greenspan: don’t worry about it too much on the upside, and on the downside do a few things to make it better. These things should be aligned with our basic principle of economic management, which is:
So, make money more stable and lower taxes. What if the Japanese government did nothing to “pop” the bubble on the way up — no huge tax hikes — and then, on the way down, actually reduced property-related taxes? And fixed the deflation problem, which actually began in 1985? Much different outcome.
With that said, sometimes things get really silly, as they most assuredly did in 2004-2007. If it seems that things are really silly, the government can exercise oversight, such as demanding that brokers and banks reduce leverage and exposure, or no mortgages with over 90% LTV (70% LTV for commercial) and fully-amortized only. And quit with the derivaties! The nice thing about this is that, if the government is completely wrong, typically little harm is done. So, the risk of being wrong is lessened. The Chinese government makes regular experiments along these lines.
This could probably be considered a variant of our Crisis Management principles.
Identify the Problem
Solve the Damn Problem
So, you would Identify that there’s a potential bubble being driven by super-easy mortgage credit, for example, and Do Something to solve that, such as demanding that banks require 80% LTV (and no piggybacks) and full amortization. This is much better than just carpet-bombing the economy with tax hikes and interest rate tomfoolery.
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Famine Watch: Okay, the famine hypothesis is rather farfetched. Maybe in 2010, but not 2009. Still, when U.S. industrial agriculture is dependent on heavy machinery from China, potash from Russia, GM seeds from Monsanto, credit from Citibank, price hedging on the Nymex, and diesel from Saudi Arabia … there’s a possibility that something could go wrong somewhere.
It’s harder for farmers to get credit for next season’s crop, especially farmers overseas. They need fertilizer, seed, fuel and more. And most farmers need to borrow money to obtain these essential items. No credit; no crops.
Therefore, the global credit squeeze might reduce plantings of key grains, even as world inventories of these grains hover near historic lows. In Russia, for example, cash-starved banks have cut off funding for the industry. The head of the Russian Grain Union says, “Many farmers probably won’t be able to borrow money for the spring sowing.” This is important because Russia is no lightweight in the grain division. It produces 9% of the world’s wheat, for instance. No surprise that the United Nations considers Russia a critical component of the global food supply.
Ironically, Russia just had its best harvest ever. And still, global grain inventories remain low. Bloomberg reports that global inventories of corn, wheat and soybeans are the second lowest they’ve ever been since 1974.
A number of countries already fear what might happen next year. The Washington Post Foreign Service in Shanghai reports that China adopted a number of measures to protect itself from the worsening food crisis: “Among the most extreme measures [China] took was to impose new export taxes to keep critical supplies such as grains and fertilizers from leaving the country.”
These taxes are extremely high, on the order of 150%-185%. China worries that richer countries may outbid its own farmers for supplies and weaken China’s own food supply. One Chinese fertilizer company, which produces 150,000 tons per year, already said that the new taxes mean exporting is no longer profitable. China was the biggest exporter of certain types of fertilizer. No longer. That’s a lot of supply off the market.
Fertilizers are absolutely critical in maintaining (and improving) crop yields. Without them, we’d produce far less per acre. As a result, in parts of Africa where people depend on Chinese fertilizers, the food supply problem is now more acute. China’s export taxes and bans follow those of other grain producers, including the Ukraine, India, Pakistan and Argentina.