September 14, 2017
Ruchir Sharma, the chief global strategist at Morgan Stanley Investment Management, used his NYT column to argue that central banks have to include fighting asset bubbles on their agenda, in addition to promoting high employment and low inflation. As someone who has argued this for two decades, I am sympathetic to the point; however, Sharma gets a couple of big things wrong.
First, the big issue with bubbles is whether they are moving the economy. This is something that is easy to determine for folks familiar with introductory economics. The issue here is whether some component of demand is out of line with its long-term trend.
That was easy to see in the late 1990s as the wealth created by the stock bubble led to a consumption boom, pushing the saving rate to a then-record low. The investment share of GDP also became unusually high, with investment concentrated in the tech sector where stock prices were most out of line with corporate profits.
The same was true of the housing bubble in the last decade. Residential construction hit a record 6.5 percent share of GDP, a level that clearly did not make sense given the underlying demographics of the country. The wealth effect from the bubble created housing wealth led to an even larger consumption boom than the 1990s stock bubble, as savings rates fell even lower than they had in the late 1990s. It is difficult to understand how the Fed could have missed the impact of the bubble or think that these sources of demand could be easily replaced when the bubble burst.
At present, there is some modest evidence that high stock and housing prices are having some effect in pushing consumption to unusually high levels. The personal saving rate has fallen to 3.7 percent in the most recent quarter, compared to a more normal 5–6 percent rate. (Bizarrely, many economists and economic reporters were genuflecting over why the saving rate was at a reasonable 5–6 percent in the years immediately following the crash, failing to recognize that consumption had simply returned to its normal level as a share of income.)
The basic point here is a simple one. The Fed need not worry about every bubble in an asset market. It only needs to worry about bubbles that drive the economy, and these are not hard to detect.
The second point is that the high interest rate solution proposed by Sharma is a very indirect way of attacking bubbles. The most simple and direct way is for the Fed to highlight the existence of the bubble in its speeches and public statements and to back this up with research (as opposed to just mumbling “irrational exuberance”).
Fed Chair Janet Yellen did this three years ago when she used her congressional testimony to call attention to bubbles in the stock of social media companies, biotech companies, and junk bonds. Her comments were accompanied by the research documenting the case. This had the desired effect of lowering prices in all three markets although the Fed did not follow through with further warnings and research.
The Fed also have a variety of regulatory tools that it can use to rein in asset bubbles. Higher interest rates are a very inefficient mechanism for reining in bubbles. The Fed’s short-term interest rate was not especially low in either the years of the stock bubble or the housing bubble. Raising rates, which slow the economy and job growth, should only be a last resort for tackling bubbles after other policies have proved inadequate.
Addendum
In looking up an item for this post I happened to stumble on this piece from three years ago commenting on bubble warnings at the time issued by Robert Rubin and Martin Feldstein. Rubin and Feldstein have been leading figures in setting economic policy for the Democratic and Republican parties, respectively, since the 1980s. Thankfully, it doesn’t appear the Fed took their warning seriously.
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