Financial Bubbles: What They Are and What Should Be Done

CEPR Basic Economics Seminar Dean BakerNovember 10, 2005

Financial Bubbles: What They Are and What Should Be DoneThe Nineties Stock Bubble: The Secrets of Simple ArithmeticThe Housing Bubble: You can always live in an overpriced houseBubbles Arent Cute: How bubbles harm the economyHow the Fed Can Burst BubblesHolding the Experts Accountable

The Simple Arithmetic of the Stock BubbleShort-term (1 day to 5 year) stock returns are unpredictable, largely randomLong-term stock returns can be predicted based on profit growth and PE ratiosForecasters (CBO, OMB, private forecasters) routinely make profit growth projections, therefore it is very simple to derive stock return projectionsStock returns have two components: capital gains (the rise in share price) and dividend payouts (including share buybacks)Stock returns = capital gains + dividend payouts DEFINITIONAL TRUTH

Projecting Stock ReturnsAssume PE is constant through time then capital gains equal the rate of growth in profitDividend payouts average 60% of profits limited by the need for reinvestmentDividend yields 60% of earnings yield (inverse of PE ratio)Therefore, stock returns = profit growth + 60% of earnings yield

Stock Returns: Normal and Bubble YearsNormalProfit growth 3.0% a year, capital gains 3.0% a yearHistoric PE 14.5 to 1, implied earnings yield 7.0 percentDividend yield = 60% of 7.0% = 4.2%Stock return = 3.0% capital gains + 4.2% dividend yield = 7.2%

Stock Returns: Normal and Bubble YearsNormal (7.2%)Nineties Bubble YearsPE crossed 20 in 1996 and 30 in 1999, so earnings yield was under 5% after 1996 and close to 3.0% in 1999The dividend yield fell from 3.0% in 1996 (60% of 5%) to less than 2% in 1999Normal profit growth was 3.0% but 1996-2000 were near cyclical peaks. CBO projected NEGATIVE real profit growth from 1999 to 2019In bubble years, projected stock returns would have been 2.0-3.0 percent from dividends, plus minimal capital gains, depending on growth assumptionsInvestors would receive much better returns from government bonds

If the PE ratio rises, then dividend yield falls, leading to ever higher PEIf the PE falls, then capital gains are negative and returns are far worse than if PE stays constantA high PE guarantees low returns unless profit growth goes through the roofProjections If the Price to Earnings Ratio Isnt Constant

In the long run, house prices nationally have followed inflationIn the long run, house prices have risen more or less with rents (same market)Unless some fundamental factor has changed, then the run-up since 1997 is a bubbleHow to Recognize a Housing Bubble

The Realtors FundamentalsPopulation growth its slower today than in prior decadesRising incomes incomes grew far more rapidly in the 50s and 60sEnvironmental restrictions on building the late 90s were not the heyday of environmentalism (Republican takeover of Congress and state houses)Limited supply of land land has always been limited; what happened to Internet removing restrictions of time and space?Low interest rates if low interest rates explain the run-up, then house prices will plummet when interest rates return to normalIt is interesting to note that the fundamentals just started to drive up house prices at the same time the stock bubble was pushing up stock prices. (Stock wealth can lead to higher real estate prices, just as in Japan in the 80s)

Bubbles: National and LocalHousing markets are local, but there are common factorsThe collapse of the bubble will not hit every market equally (the collapse of the stock bubble didnt hit every stock equally) but virtually all markets are likely to see price declinesHigher interest rates will likely lead to a collapse, but overbuilding will eventually saturate the market, even without an increase in interest rates

Bubbles and the EconomyWhy They Arent Cute

Misdirected investment companies with no real future get billions to investInflated stock prices conceal accounting fraud (e.g., WorldCom, Enron, Global Crossing)Consumer wealth effect people spend based on stock wealth that is not there; they dont have retirement savings when neededUnder-funded pension funds (e.g., Delphi, United, Northwestern, etc.) as pension fund managers had assumed bubble would lastCollapse leads to a demand gap (a.k.a. recession) that is difficult to counteractHow the Stock Bubble Harmed the Economy

How the Housing Bubble Harms the EconomyOverbuilding in housing due to bubble inflated prices, resources that could have been better invested elsewhere are spent constructing big homesConsumer wealth effect people spend based on housing wealth that is not there; they do not have retirement savings when neededPossible financial panic when bubble bursts, secondary mortgage market (Fannie Mae and Freddie Mac) could be in dangerCollapse leads to a demand gap (a.k.a. recession) that is difficult to counteract.

How the Fed Can Burst BubblesIt is the Feds job Greenspan intervened to stem the stock crash in 1987. He intervened in the unraveling of the Long-Term Capital Hedge Fund in 1998. The stock and housing bubbles have gar more impact on the economy than either of these eventsThe Fed has regulatory tools margin requirements on stocks, lending soundness on housing.Interest rates higher interest rates can burst bubbles.

Fed Talk (or Treasury Talk)The Best Weapon Against Financial BubblesThe Fed chair and the Treasury Secretary have enormous audiences for their pronouncementsIf either of them clearly laid out the rationale for a stock or housing bubble (e.g., showed my charts) then every investment manager and financial advisor in the country would have to be familiar with the argument.Any investment manager or financial advisor who simply ignored these arguments would risk being fired and possibly sued for negligence.Talk is cheap; why not do it?

Holding the Experts AccountableIt was possible (in fact easy) for any professional analyst to recognize the stock bubbleIt is possible (in fact easy) for any professional to recognize the housing bubble.Custodians get fired when they dont do their job; why dont economists, financial analysts, investment managers, and policy analysts? (Everyone else was wrong too doesnt cut it.)The Congressional Budget Office and Social Security Administration have consistently made stock return projections for Social Security privatization that they cannot support.CBO over-estimated projected revenues in 2000 by close to $1 trillion over a ten year time frame (0.8% of GDP) because it assumed that the stock bubble would persist indefinitely. (No one was fired.)

ConclusionsIt is possible to recognize bubbles financial markets are not that mysteriousFinancial bubbles cause enormous economic damage far more than modest increases in the inflation rateThe Fed and Treasury can and should act to counteract bubblesEconomists, business, and policy professionals who cannot see financial bubbles should find another line of work

Reading ListBaker, D. and D. Rosnick, 2005. Will a Bursting Bubble Trouble Bernanke? The Evidence for a Housing Bubble Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/housing_bubble_2005_11.pdf].

Baker, D. 2002. The Run-Up in Home Prices: Is It Real or Is It Another Bubble? Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/housing_2002_08.pdf].

Baker, D. 2000. Double Bubble: The Implications of the Over-Valuation of the Stock Market and the Dollar, Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/double_bubble.pdf].

Kindleburger, C. 2000. Manias, Panics, and Crashes: A History of Financial Crises. New York: John Wiley and Sons.

Shiller, R. 2005. Irrational Exuberance, Princeton, NJ: Princeton University Press.

Financial Bubbles: What They Are and What Should Be Done

Dean Bakerbaker@cepr.net

Center for Economic and Policy Researchwww.cepr.net