Examining the Possibility of Bubbles on the Horizon

Predicting the future is often difficult and regularly produces failures due to the sheer amount that’s happening in the world, but I think this op-ed by one of the few economists who spotted the significant housing bubble is worth reading.

Ever since the collapse of the housing bubble in 2007–2008 that gave us the Great Recession, there has been a large doom and gloom crowd anxious to tell us another crash is on the way. Most insist this one will be even worse than the last one. They are wrong.

Both the housing bubble in the last decade and the stock bubble in the 1990s were easy to see. It was also easy to see that their collapse would throw the economy into a recession since both bubbles were driving the economy. We are in a very different place today.

The stock market is high. By any measure, price-to-earnings ratios are far above historic averages, but they are nowhere near as out of line as they were in the 1990s bubble.

The current value of the market is roughly 24 times after-tax corporate profits, based on the first quarter’s data. This compares to the historic average ratio of 15-to-1. But at the peak of the bubble in 2000, the ratio was over 30-to-1.


It is true that profits are unusually high as a share of national income. This reflects a big increase in the profit share in the weak labor market following the Great Recession, and more recently the Republican tax cut passed last fall.

It can be hoped that labor regains some of its lost share and pushes profits downward. But there is no guarantee that this will happen, and stock prices that reflect current profit levels can hardly be said to be in a bubble.

House prices are also well above trend levels. Inflation-adjusted house prices are around 30 percent above their trend levels. But they are still about 14 percent below bubble peaks. Here too, the higher than normal level seems to reflect the fundamentals of the market.

Unlike the housing bubble years, rents have been rising far more rapidly than the overall rate of inflation over the last five years. This indicates that there actually is a shortage of housing pushing up house prices, not a speculative bubble.


Not only is there little evidence of bubbles just now, there also is no case to be made that bubbles are driving the economy. In the late 1990s, it was clear that the stock bubble was driving the economy. Through the stock wealth effect, the run-up in stock prices led to a consumption boom that pushed the savings rate to then-record low levels. In addition, investment surged as this was a rare period in which start-ups were actually financing investment by issuing shares of stock.

When the bubble burst, investment plunged, and consumption fell back to more normal levels. This gave us the 2001 recession. While most economists see this as a short and mild recession, we actually did not recover the jobs lost until January of 2005, which at the time was the longest period without net job growth since the Great Recession.

In the housing bubble years, the consumption triggered by the run-up in house prices sent the savings rate even lower than at the peak of the stock bubble. In addition, housing construction rose to 6.5 percent of GDP, compared to an average of roughly 4.0 percent.

Not surprisingly, when the bubble burst consumption fell back to more normal levels. The overbuilding of the bubble years led construction to fall far below normal levels, bottoming out at less than 2.0 percent of GDP in 2010. This enormous loss of demand was the cause of the Great Recession.

High stock and housing prices are not driving the economy in the same way as they did in the 1990s stock bubble or the housing bubble of the last decade. Investment remains modest by any measure. Housing construction is getting stronger, but very much in line with longer-term trends.

Consumption is high as a result of stock and housing wealth. But even in an extreme case, where the savings rate rose back to Great Recession levels, it probably would not be sufficient by itself to cause a recession and certainly not a severe one.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s