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.

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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.

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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.

There Isn’t a Giant Bubble Threatening the U.S. Economy

The U.S. economy isn’t doing real well for most people, but it currently isn’t threatened much by a bubble as giant as the housing bubble that spawned the economic crash of 2008. Because there’s importance in knowing the basics of what happened then, I’ll relay the analysis of it from one of the few people who saw the housing bubble.

There has been much greater concern about the danger of asset bubbles ever since the collapse of the housing bubble sank the economy. While it is good that people in policy positions now recognize that bubbles can pose a real danger, it is unfortunate that there still seems very little understanding of the nature of the problem.

First, an economy-threatening bubble does not just sneak up on us. Often the discussion of bubbles implies that we need some complex measuring tools to uncover an economy-threatening bubble that’s lurking in some far corner of the data.

This is absurd on its face. If a bubble is large enough to threaten the economy, it is hard to miss. This was true of both the stock bubble in the 1990s and the housing bubble in the last decade.

At the peak of the stock bubble in 2000, the ratio of stock prices-to-trend corporate profits was more than twice its long-term average. This may have been justified if there was an expectation that profit growth was going to be much faster in the future, but almost no economic analysts projected this speed up.

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In the case of the housing bubble, inflation-adjusted house prices had risen by more than 70 percent above their long-term trend. This unprecedented run-up in house prices occurred at a time when rents were essentially moving in step with the overall rate of inflation, suggesting that there was no major shift in the fundamentals of the housing market. Furthermore, vacancy rates were already at record highs even before the bubble burst, providing clear evidence that house prices were not being driven by a shortage of housing.

And, both bubbles were clearly moving the economy. In the case of the stock bubble, investment hit its highest share of GDP since the late early 1980s, as start-ups were taking advantage of sky-high share prices to finance crazy schemes. Also, the wealth generated by the stock bubble led to a surge in consumption that pushed the savings rate to a then-record low.

In the case of the housing bubble, high prices led to a flood of new construction, raising the residential investment share of GDP to almost 6.5 percent, compared to a long period average of less than 4 percent. The wealth created by the housing bubble led to an even larger consumption boom than the stock bubble.

All of this was easy to see from widely available government data sets. It required no more than an Excel spreadsheet to analyze these data. So this was not rocket science, it was basic economic logic and arithmetic.

Should we be concerned about a bubble now? Stock prices and housing prices are both high by historical standards. The ratio of stock prices-to-trend corporate earnings is more than 27-to-1; this compares to a long-term average of 15-to-1.

House prices are also high by historic standards. Inflation-adjusted house prices are still well below their bubble peaks, but are about 40 percent above their long-term average.

In both cases, these markets are high, although in ways that are at least partly explained by the fundamentals of the market. In the case of stock prices, the profit share of GDP is almost 30 percent above its trend level. If this persists, then the ratio of prices-to-earnings is much closer to the long-term average. Of course, a big cut in the corporate tax rate increases the likelihood that a high-profit share in GDP will continue.

Extraordinarily low-interest rates (both real and nominal) also mean that stocks provide a relatively better return compared with alternatives like bonds and short-term deposits. This also would change if interest rates rise substantially, but for now, that doesn’t seem likely.

The run-up in house prices also seems less disconcerting when we consider there has been a parallel run up in rents. While rents have not increased as much as house prices, they have been substantially outpacing the overall rate of inflation for the last five years. Low-interest rates would also help to explain house prices being above long-term trends, as they justify a higher ratio of sales prices-to-rents.

Here also, there is a risk that higher rates could send prices tumbling. This could be an especially bad story for moderate-income homeowners, since the bottom tier of the housing market has seen the largest price increases over the last five years.

But even in a bad story, where for example higher interest rates send both stock and house prices back towards their trend levels, we don’t have to fear an economic collapse and probably not even a recession. The high stock market is not driving investment, which remains very modest despite near record-high after-tax profits. Housing construction has come back from its post-crash lows, but is roughly in line with its long-term average share of GDP.

The loss of trillions of dollars of wealth would be a hit to consumption. Consumption has been unusually high in recent years with the savings rate averaging just 3.6 percent of disposable income in the last year. A more normal savings rate would be closer to 6 percent. But even if the savings rate were to rise to 6 percent over a span of a year or two, it would likely dampen growth rather than cause a recession.

In short, there is little reason to think that the economy is threatened by the risk of collapsing bubbles at the moment. This doesn’t mean that holders of large amounts of Bitcoin or Amazon stock may not have something to worry about, but most of us don’t.