Arnold Kling  

Bubble Talk

Hanson Link Fix... Speaking of Bubbles...

Steven Pearlstein writes,

nearly every asset market you can think of is showing signs of bubblelike behavior. The reason is pretty clear: The global economy is awash in free cash.

The article makes a number of interesting allegations, not all of which I agree with. For example Pearlstein says that one would expect a lot of saving from baby boomers. Well, one may expect it, but it is not clear that we are getting it.

He says that China is printing a lot of money. That would explain why asset prices are rising in terms of Chinese currency, but not why they are rising in terms of dollars. And, if what China is doing is pegging their currency to the dollar, then if there is a monetary culprit in the alleged bubbles, it is the U.S. central bank.

In the oil market, Pearlstein writes

Phil Verleger, the energy expert...said OPEC and its silent partners, the major oil companies, know that they earn the highest profit when oil inventories are lean, and the best way to keep them lean is to keep spot prices higher than futures prices.

I have no idea how the oil producers can contrive to manipulate spot prices higher than futures prices. This phenomenon of backwardation has long puzzled me.

My view of the oil market is that speculators have been continually surprised by demand-supply imbalances. For a long time, people had conditioned to expect that when oil prices rise, they must come down.

In October, when oil was at $40 a barrel, I did not think it was a bubble. Right now, $40 would look cheap.

For Discussion. Is too much money chasing too little oil and real estate?

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COMMENTS (7 to date)
Winston writes:

One of the best books I've ever read on economics is also one of the most simplest. It was a collection of essays by Von Mises (title escapes me). I didn't major in economics in college (my math skills were too limited), but I loved the way VonMises simplifies very complex theories. One of the most memorable essays was about the Quantity Theory of Money and how rising price indices weren't a phenomena, but directly related to the amount of money in circulation. I believe there are too many dollars chasing to view goods! I can't scratch out the math behind it, but I think there's enough empirical evidence to support it. I wonder if this is the last evening before a major global depression.

Lancelot Finn writes:

If real estate and oil are undergoing inflation, it is interesting that inflation in general remains low. This fact highlights how effectively technology and globalization have diminished the prices of many goods.

Real estate is in part a status good. It's cool to live in certain places. While it's possible to increase the supply of widgets dramatically, it may not be possible to increase the supply of status. If we produce widgets much more efficiently, the price of status in widgets should rise. To the extent that real estate is not a status good, I wonder if its price is really rising. Are big houses in small towns in Indiana more expensive than they used to be?

How should policymakers respond to an increase in productive efficiency which makes the prices of real estate and oil rise relative to most other goods diverge from the price of manufactured products? If you pursue a contractionary policy that holds real estate and oil steady, that might lead to deflation in the prices of manufactured goods. Which is worse: asset-price inflation, or manufactured-goods deflation? If I had to guess, I'd say the latter.

However, mightn't there be other policies to combat asset-price inflation? For example, there are growth restrictions in a lot of major cities. Growth restrictions reflect an insider-outsider problem. Owners of prime real estate can benefit from colluding to restrict supply by preventing anyone from building, say, high-rise apartment buildings. This helps the landlords at the expense of people who are prevented from moving into the prime area by growth restrictions. Is there any way Congress could (constitutionally) act against growth restrictions?

As for oil: raise gas taxes! Put a floor under gas at $3 a gallon. That will encourage people to drive smaller cars and/or live nearer to the center of cities. It will also encourage nifty trends like telecommuting.

touche writes:

For Discussion. Is too much money chasing too little oil and real estate?

See global economy falls into a "debt trap" at

Lawrance George Lux writes:

Pearlstein stands as basically wrong, from my estimate. There is real bubble behavior in the Markets, basically produced by Tax rates which are too low here and in the World, coupled with the tax incentives to invest. Corporations have been issuing Stock for decades--for Acquitions and Stock Options\Stock Grants for Executives and Personnel. P/E ratios stink, and real equity is diluted.

In answer to your question, the Inflation since the 1993 Tax law has come in declining equity Stock issuances, due to alteration of the 1993 Tax law. There is too much money in Oil and Real Estate as the Money chases good P/E ratios, it being the result of extremely bad Tax policy--not only in the United States.

I know Libertarians, Conservatives, NeoConservatives, and Corporate types will appreciate this assessment. lgl

New Economist writes:

The first problem with asset bubbles is identifying them at the time. The second problem (for central bankers and government) is working out what, if anything, to do about them.

Fortunately for the Fed their own economists have concluded that you can't identify bubbles. See "Econometric Tests of Asset Price Bubbles: Taking Stock" by Refet S. Gurkaynak, Finance and Economics Discussion Series 2005-4.

So they needn't worry about the second problem....

dsquared writes:

This is the best recent thing I've seen on normal backwardation. Note that under the classic (Keynesian) theory of backwardation, it's oil consumers, not producers, who are responsible for backwardation.

As I understand it there are two things going on here; oil and oil futures are better substitutes for producers (the net longs) than they are for consumers (the net shorts). The idea being that if I'm an oil company, I want to make money and I don't care if I make it on oil or oil futures. But if I'm an oil purchaser, I want to burn it or refine it or make plastic out of it, and you can't really do that with futures. Hence, there is always going to be a disconnect between the spot and the futures demand.

Second, the arbitraging of that gap is complicated by an implicit option premium created by the asymmetry of oil drilling. Oil which is pumped can't be put back in the ground, but oil which is not pumped now can be pumped later. Therefore, in order for a producer to pump the oil, he has to be compensated not only for the cost of pumping, but also for the option premium; the cost of pumping now rather than later. This premium is, like most option premia, poorly understood and volatile, so nobody can rely on any sort of law of one price obtaining between oil and oil futures. Hence, normal backwardation.

Randy writes:

The economy isn't "real". It is an attempt to measure, clarify, and predict, the ebb and flow of human desire and creativity. But beyond subsistance, it's all "bubble". I am amazed that something so fragile can be so strong.

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