(I am an occasional contributor to roundtables of economists in the magazine The International Economy. This month’s topic was “What about the Risk of a Bursting Asset Bubble?”, with corporate debt and equity mentioned as possibilities. Contributors were asked to rank their level of concern from 1 to 10. My response is below.)
Any time you have an asset held primarily for capital gains, a story that allows people to extrapolate from recent price increases to future ones, and a reasonably elastic credit system, you have the ingredients for a bubble. The question is not whether there will be bubbles, but how damaging they will be, and what steps we should take if we think one is developing in a particular asset market.
Corporate debt is an unlikely asset for a bubble. Unlike with equity, real estate, or currency, there are clear limits to potential capital gains. High levels of stock buy- backs are problematic for a number of reasons, but they don’t particularly suggest a bubble. When a greater share of corporate value added is paid out to shareholders rather than retained and invested or paid to workers, that may be bad news for the economy in the long run. But it is good news for owners of corporate stock, and there’s nothing strange about it being priced accordingly.
Cryptocurrencies are a better candidate for a bubble. It’s safe to say they are mostly held in expectation of capital gains, since they pay no income and, despite the promises of their boosters, have limited utility for transactions. It wouldn’t be surprising if their value fell to a small fraction of what it is today.
But that brings us to the question of how damaging a bursting bubble will be. The housing bubble was exceptionally damaging because housing is the main asset owned by most middle-class families, housing purchases are mostly debt-financed, and mortgages are a major asset for the financial system. It’s hard to see how a collapse of bitcoin or its peers would have wider consequences for the economy.
The other question is what to do about a bubble if we have reason to believe one is forming. One common answer is to raise interest rates. The problem is that, historically, there’s no sign that low rates are more favorable to bubbles than high ones. The 1980s savings and loan crisis took place in an environment of—indeed was driven by—historically high interest rates. Similarly, Sweden’s great real estate bubble of the late 1980s took place when rates were high, not low.
And why not? While productive investment may be discouraged by high rates, expected capital gains at the height of a bubble are too high for them to have much effect. This was most famously illustrated in the late 1920s, when the Fed’s efforts to rein in stock prices by raising rates did a great deal to destabilize European banks by reversing U.S. capital outflows, but had little or no effect on Wall Street.
A better policy in the face of a developing bubble is to directly limit the use of credit to buy the appreciating asset. Tighter limits on mortgage lending would have done far more than higher rates to control the housing bubble of the 2000s.
In other cases, the best policy is to do nothing. As economists going back to John Maynard Keynes have observed, a chronic problem for our economy is an insufficient level of investment in long-lived capital goods and new technology. To the extent that inflated asset values encourage more risky investment—as in the late 1990s— they may be even be socially useful.
By all means, let’s take steps to insulate the core functions of the financial system from speculation in asset markets. But holding macroeconomic policy hostage to fears of asset bubbles is likely to do more harm than good.
Weighing the chance of a major bubble along with its likely consequences, I’d put my concern over asset bubbles at three out of ten. The biggest danger is not a bubble itself, but the possibility that a fear of bubbles will prompt a premature tightening of monetary policy.