Taking asset bubbles seriously
from Dean Baker
Last month at an International Monetary Fund conference, former Obama economic advisor Lawrence Summers harshly criticized outgoing Federal Reserve Board Chairman Ben Bernanke for comments he made this summer. Bernanke had raised the possibility of tapering the Fed’s purchase of treasury bonds, which would cause interest rates to rise. With the economy facing a prolonged slump, Summers argued, Bernanke should not even have talked about raising interest rates.
While Summers is correct that the economy remains far below its capacity, and therefore policy should be focused on boosting employment for the foreseeable future, there was actually a real problem that may have sparked Bernanke’s taper talk. The housing market was again approaching the price levels seen during the housing bubble, whose collapse six years ago precipitated the downturn and the financial crisis.
At the end of the second quarter of this year, the inflation-adjusted value of the Case-Shiller national home price index was more than 20 percent above its pre-bubble level. It was only 8 percent below its 2002 level, the point at which economists first began warning of a housing bubble.
More important than the current level of prices was the rate of change. House prices nationwide were up 10.1 percent from their level a year ago. In several markets prices were rising considerably more rapidly, with rates of price increase of more than 30 percent. Even if house prices were not yet out of line with fundamentals by the time of Bernanke’s taper talk, they soon would be in the markets showing rapid double digit price increases.
Even worse, these markets were mostly the ones that had taken the biggest hit in the housing crash. The bottom third of the market in cities like Phoenix and Las Vegas were showing especially rapid rates of price increase, as were many of the price of homes in the central valley of California.
The price run-ups in these markets appear to have been largely driven by investors. Homeowners, however, inevitably get caught up in the frenzy. And this is one of the reasons why it is incumbent on policymakers to take bubbles seriously. It is a financial catastrophe when someone takes their life’s savings and borrows every penny they can to buy a home for $300,000 only to see it selling for $200,000 two years later.
Ideally the Fed would learn to counteract bubbles with other instruments. It has enormous regulatory authority, which could be used to block the flow of credit that typically fuels a bubble. It can also try talk, in the sense of explicitly warning of bubbles and using Fed research to document their existence.
Economists laugh knowingly at the suggestion that the Fed could talk down an asset bubble, even if the talk included an explicit threat to use interest rates against the bubble if talk and regulatory measures failed to do the job. This scorn is interesting because many economists now accept the idea that talk in other contexts, specifically “forward guidance” on interest rates, can have a major impact on behavior.
In that context, economists believe that the Fed can lower long-term interest rates in the present by committing to low short-term interest rates in the future. It must take a very sophisticated knowledge of economics to understand how the Fed’s statements about the future course of interest rates can influence markets, but its statements about house prices, with an implicit or explicit threat of action, cannot affect house prices.
Whether deliberately or not, Bernanke’s taper talk stemmed the growth of an incipient housing bubble. Summers obviously believes that Bernanke acted wrongly. So what is Summers’ recipe to prevent the growth of a bubble?
If there is no answer to that question, then Summers’ critics have been right to identify him as someone who deliberately promotes bubbles as a way to counter stagnation. Many economists remember that Summers was Treasury Secretary as the stock bubble reached its peak in 2000 and later derided those who raised concerns about the housing bubble.
Whatever his past role, if Summers is to preserve his credibility on this issue, he and his defenders must come up with a course of action that would rein in bubbles without sinking the economy.