We talked yesterday about how consumer price inflation has been pretty moderate, and why that is. To recap: The speed at which money circulates has declined, even as the Fed forces bank reserves into the financial system, meaning that when the economy recovers, when the banking system gets its mojo back, and when lending starts to take off again, we can expect inflation to accelerate—potentially very much so.
A point worth mentioning here is that the Fed does have tools it can deploy to help limit inflation. And although the Fed has said it will wait to do so, inflation is actually a problem we know how to solve. This is something to watch, therefore, but shouldn’t become a long-term systemic problem.
If the Fed knows how to handle consumer price inflation, though, it’s not nearly so good at recognizing, much less dealing with, asset price inflation. We have the Fed on record, through at least two bubbles—stocks in the late 1990s, housing in the mid-2000s, and, arguably, stocks again in the mid-2000s—saying it could not recognize a bubble in progress; that if it did, it couldn’t do anything about it; and that its best course of action was to help clean up the mess. Which led us to 2009 and afterward.
I disagree with this on many levels, but let’s start with the ability to recognize a bubble in asset prices. Drawing on Hyman Minsky’s work, I would propose a simple test for a bubble: an asset class where prices rise in line with the increase in the availability of financing. In other words, debt is driving the price increases. This makes intuitive sense (consider the recent housing bubble, which was driven by unprecedented availability of mortgage financing), with the added benefit of being observable by comparing debt buildup with asset prices in many areas. It also has the virtue of providing some predictive power—for example, as to whether the current housing recovery represents another bubble forming.
As perhaps the best example of a debt-induced bubble, let’s look at housing prices and mortgage debt over the 2000s, shown in the following chart. The data, unfortunately, is kind of choppy, but the trend and the correlation are clear.
You can see a high correlation between growth in mortgage debt and changes in house prices on both the upside and the downside, which is consistent with what we expected. Correlation is not causation, of course, but given our understanding of how buyers behaved, it seems a reasonable conclusion. We can also look at more recent data to see whether the housing recovery is debt-based and, therefore, potentially another bubble.
Over the past five years, in contrast, there has been no correlation between mortgage debt and house prices. There could be several explanations for this, but it seems clear that it’s not debt driving the house price recovery. That is, the recovery in housing is real.
The other test case for our bubble model is the stock market. As you can see in the following chart, over the 2000s, stock prices rose in line with margin debt, which suggests bubble-like behavior. The decline of both, again in synchrony, further supports that idea.
The problem here is that, unlike the housing market, where the recovery of the past five years has not been driven by debt, the stock market shows exactly the same behavior as from the mid-2000s. If you accept that debt can drive asset prices up, if you accept that this is a reasonable definition of a bubble—and if you accept the Fed’s stated goal to use low interest rates and debt to reflate asset prices—you have to consider the possibility that current stock prices are in a bubble.
After preparing this presentation, I found a much more detailed analysis of this point by Doug Short, an excellent analyst. Rather than try to summarize his work, you can find it here. Definitely worth a read.
The takeaway from today is that money can indeed drive asset price inflation, including bubbles, even as consumer price inflation remains constrained—just like in the mid-2000s. If you use the debt/price connection as a definition of a bubble, which I think is reasonable, then the current housing recovery is real, but the stock market satisfies the bubble condition. Given, again, that this is consistent with stated Federal Reserve policy, I don’t think the idea is unreasonable.
What to do? Be willing to buy a house. Be careful in the stock market, per any number of previous posts on this blog. And pay attention.
Tomorrow, I will conclude this series with a discussion of the role of the dollar in the world economy. Exchangeability and scarcity will return to the conversation, and we will consider whether the widely publicized currency collapse will happen. Short answer: no.