The Trouble with Bubbles
Spotting and responding to asset price bubbles
Posted by Dennis Dillon, Senior Market Insights Analyst, Banking & Securities, Deloitte Services LP, on July 30, 2014
Bubbles, or at least potential bubbles, seem to be everywhere lately. Skyrocketing tech valuations have led to conclusions that we're seeing a new tech bubble.1 References to a student loan bubble have become commonplace, albeit contested.2 And some commentators even worry about a re-inflated housing bubble.3 No wonder the New York Times has wondered about an "everything bubble."4
These labels are controversial, but they aren't fringe concerns: the Bank for International Settlements recently warned of overly buoyant global financial markets.5 And as the market turmoil of 2007-2008 showed, banks and capital markets firms need to account for even seemingly minor risks of major mis-pricing. A deflating bubble can wreak havoc on balance sheets and sow confusion across financial markets. But if the phenomenon seen isn't actually a bubble, action to mitigate it — typically an increase in interest rates — could harm both a particular sector as well as the broader economy.
In short, dealing with bubbles is difficult. Mistakes in either direction have severe consequences. These high stakes mean having a rigorous framework for assessing bubbles and possible interventions is crucial.
A short 2005 paper by Glenn Rudebusch of the San Francisco Fed offers a simple way to consider these issues. Briefly, the decision to intervene — usually by central banks such as the Federal Reserve — must pass three hurdles:
- Can we say for certain it's a bubble?
- Can the consequences of a potential bubble be offset after the fact?
- Is the proposed intervention a good way to deflate the bubble?
Passing each of these checks may seem straightforward, but examining them individually shows how difficult bubble management can be.
Is it a bubble?
A bubble is defined by divergence from fundamentals (often incorporating a speculative component) leading to an unsustainable build-up in prices. But intrinsic value is a tricky concept, and economic and financial trends depend on a wide range of factors. To say valuations are unjustified requires an unusually complete understanding of the dynamics.
Take the dot-com bubble of the late 1990s. Identifying it as a bubble beforehand was difficult: the next logical step of the computer revolution did indeed seem to be a dramatic expansion of the Internet ecosystem. And in December of 1996, when Alan Greenspan made his famous comment about "irrational exuberance," the boom still had years to run. In fact, the NASDAQ Composite at that time was only somewhat higher than its 2002 trough.6
Can the consequences be offset after the fact?
Dealing with a bubble after it bursts has some clear advantages. Perhaps most importantly, policymakers don't have to guess whether an asset price shift indicates a bubble. And calibrating the policy response will be easier when authorities know the magnitude of the problem — as long as the damage isn't too severe to contain.
The dot-com bubble again offers a useful example. Containing the damage after an eye-watering drop in stock prices proved relatively manageable: quick rate cuts likely helped keep the recession mild by historical standards.
Would the proposed policy intervention be a good way to deflate the bubble?
The first stop for macroeconomic interventions is often monetary policy. But an interest rate hike — the most basic way to cool overheated markets — is a blunt tool at best, because it affects the whole economy at once. The damage done by monetary tightening, especially in a fragile economic environment, may outweigh the benefits. (That's why many policymakers have advocated macroprudential regulation as a primary tool for maintaining financial stability.7)
Cases of premature action against a bubble are difficult to find; central banks historically have hesitated to act pre-emptively. But when the Swedish central bank raised rates in 2010 for fear of rising household debt, inflation fell well below target, indicating weakened demand across the economy.8
The takeaway isn't that we shouldn't try to fight bubbles; the experiences of the last decade show that some do warrant intervention. But as even the brief examples highlighted here show, identifying bubbles can be hard, and as the contrasting cases of the housing bubble and dot-com bubble show, knowing when to take action may be even harder.
These difficulties highlight a clear need for additional research on bubble formation. They also show that improving tools for monitoring asset prices and gauging investor sentiment should be a priority; banks and other capital markets players may be able to work with authorities to develop innovative approaches to these goals.
In the meantime, banks may wish to carefully assess claims of new bubbles and demands for counter-bubble policies. As they do so, they should bear in mind the framework and examples discussed here.
1Steven Russolillo, "David Einhorn: ‘We Are Witnessing Our Second Tech Bubble in 15 Years'," Moneybeat (blog), Wall Street Journal, April 22, 2014.
2Julie VerHage, "The Next Big Bailout: Student Loans," Fox Business, June 3, 2014, http://www.foxbusiness.com/economy-policy/2014/06/03/next-big-bailout-student-loans/.
3Prashant Gopal and Kathleen M. Howley, "From Brooklyn to California, Housing Bubble Threat Grows," Bloomberg, May 16, 2013, http://www.bloomberg.com/news/2013-05-16/brooklyn-to-california-bubble-threat-grows-in-housing.html.
4Neil Irwin, "Welcome to the Everything Boom, Or Maybe the Everything Bubble," New York Times, July 7, 2014.
5Bank for International Settlements, 84th Annual Report, June 29, 2014.
7Janet L. Yellen, "Monetary Policy and Financial Stability," speech at the International Monetary Fund, July 2, 2014.
8Simon Wren-Lewis, "The financial instability argument for raising rates," Mainly Macro (blog), July 1, 2014.
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