Scott Sumner  

Do barriers create "bubbles?"

PRINT
Robert Frank's Confusions... Minimum Wage Not Well Targeted...

Ryan Avent discusses a recent speech by Larry Summers:

The basic set-up of his narrative remained unchanged from last year. Imagine a world, he said, in which resources are increasingly concentrated in the hands of those with high propensities to save and low propensities to invest: reserve accumulating foreign governments, for example, and the very rich. In that world, the real rate of interest that clears the market--that balances savings and investment and therefore ensures that no willing workers are left unemployed--could fall to and remain at very low levels.

It could fall to such a low level that the central bank would need to keep its policy rate near zero to clear the market; with interest rates near zero, asset prices would soar, such that a full-employment equilibrium inevitably meant a dangerous rise in financial instability. Alternatively, the market-clearing interest rate could fall below zero, leaving the central bank unable to move its policy rate low enough to generate adequate demand and trapping the economy in a prolonged slump.

Ryan has lots of astute things to say about that final sentence, but I'd like to focus elsewhere.  I've also argued that low rates will create more "bubbles" in the 21st century. Scare quotes reflect the fact that I don't believe in bubbles, when I say "bubbles" I am referring to unusually high asset prices, by historical standards.

Bill Woolsey has a good counterargument:

One of Summers' arguments for fiscal policy is that the low interest rates generated by monetary policy results in excessively high asset prices.

While it is true that given the expected return on an asset, a lower interest rate raises the asset's present value, the problem is supposed to be "secular stagnation."   There is an excessively high supply of saving and excessively low demand for investment.

But the low demand for investment is being generated by low expected returns on real investment.   Given the interest rate, that results in a lower present value of an asset.   And to the degree that excessive saving is driving down the marginal return on investment, the result is the same.

And so, secular stagnation should lower asset prices at a given interest rate. The lower interest rate, then, simply dampens the decrease in asset prices.

Can we agree with both of them?  Let's try.  I claim that during the first period of extended low interest rates (1930-51), the US was in a Woolsey world.  There weren't many asset price movements that looked like bubbles.  That's because if the price of assets like apartment buildings in Manhattan or car factories in Michigan started rising, people and companies would simply build more of those assets. It was easy to do.  So the low marginal returns on investment also reflected low average returns on assets.  Asset values remained moderate.

Today when the price of apartment buildings in New York or the price of residential housing developments in San Jose soar in value, people don't build very many more of them, as it's hard to get permission.  And when the value of Facebook and Twitter rise, people don't build more Facebooks and Twitters, because copyright laws forbid this.  Of course they could build more Facebook-like firms, but many of these companies have important network effects, or sell output at a zero price and rely on ads (winner-take-all).  Or they require a genius with a new idea.  That makes it harder to break into this industry than it was to start a new refrigerator factory in Ohio in 1947.

My prediction is that in a low interest rate America, asset "bubbles" are most likely to form in sectors with barriers, such as coastal real estate and NASDAQ stocks that are "intellectual property" plays.  And bubbles are less likely in Chinese stocks, as China relies more heavily on basic manufacturing, which can be replicated.

So a combination of low real interest rates caused by very weak returns on capital at the margin, and high average returns on infra-marginal capital in sectors protected by zoning and IP laws, will create "bubbles."

And that's as it should be given those laws exist.  Of course both zoning and IP laws should be weakened, even if we didn't care about inequality.  And if we do care about inequality then the argument for weakening zoning and IP laws becomes almost overwhelming.  Ditto for occupational licensing laws.

PS.  I realize that my theory doesn't always work; there were those high Chinese stock prices in 2007, and the high Phoenix house prices in 2006.


Comments and Sharing





COMMENTS (25 to date)
Mark V Anderson writes:

Scott, I wish you would explain what you mean that you don't believe in bubbles. I would define bubbles in two possible ways:
1) When asset prices are unsustainable because they have gotten higher than the fundamentals would yield, or
2) When much of the trading of these assets is for speculation. These buyers don't really want the assets; they just believe that others will pay more in the future.

Also a wikipedia explanation:
http://en.wikipedia.org/wiki/Economic_bubble

Obviously these definitions don't tell us when asset prices are in a bubble, but they do make it possible to talk about the concept of bubbles. Do you believe that such situations never happen? Or do you define bubbles differently?

kebko writes:

At the height of the housing boom in Phoenix, there were lotteries at some new subdivisions where there might be 6 new lots released that week and 15 people who wanted to buy them. If you wanted a house that week, you had to go to the sales office on Saturday morning, put your name in a hat, and see if you were picked.

I don't understand what factors were involved there, or why builders wouldn't be able to get more lots released, but there did appear to be some limit on supply, even in Phoenix, for some period of time.

Scott Sumner writes:

Mark, It seems to me that the only useful definition (if bubbles existed) would be predictable violations of the EMH. That is asset price levels that were clearly too high or low, and hence likely to be reversed within a few years.

I realize there are other definitions, but they seem too vague to be very useful (at least to me.)

kebko, I heard the same thing, and must admit I don't know what was going on in Vegas and Phoenix.

Michael Moran writes:

The housing bubble was most pronounced in "sand" states, Nevada, California, Florida, and Arizona. States like Texas and Oklahoma did not have a housing bubble despite rapid growth. The reason is it was very time consuming to entitle lots in the sand states. California has an extreme regulatory climate where it takes 5 years or so to move raw land to a lot which can be built upon (and it has nothing to do with the "coast", as the bubble, and subsequent drop in price was by far most severe in the interior). Nevada and Arizona has severe water issues which must be addressed before a lot can be developed, and Florida has strict law governing land usage which delays lot development.

In Oklahoma and Texas in 6 months a wheat field can become a housing development.

Scott Sumner writes:

Thanks Michael, That makes a lot of sense to me. Of course there's still the long run issue. Were buyers "rational" in expecting the high prices in Florida, Arizona and Nevada to persist?

ThomasH writes:

Very sensible.

Focusing on making taxes and regulation more growth friendly ought to be a project of liberals as much as of libertarians. A shift in taxation away from business and low wage income toward environmental externalities -- CO2 emissions, congestion, antibiotic use, etc. -- and a progressive consumption tax would be part of this project. And making sure that the bottom half shares in that growth through policies like earned income tax credits and macroeconomic management to avoid high unemployment ought to be a project of libertarians (for principled reasons) and conservatives (for political economy reasons) as much as liberals.

In a nutshell, liberals need to be less suspicious of growth that might make rich people richer and conservatives-libertarians need to be less suspicious of policies that might redistribute the fruits of that growth.

Dr. Swaggington writes:

If I remember correctly there was a lot of talk about adverse tax incentives encouraging investment in housing, as well as laws obligating to lend to poorer borrowers. As always, it's not just the barriers, but also too much encouragement. I'd say any time people discourage other options, or encourage one option, it'll obviously go up in value.

Michael Byrnes writes:

Is there a "barrier" story for the dot.com bubble?

As a liberal, I agree strongly with this part of ThomasH's comment:

"liberals need to be less suspicious of growth that might make rich people richer "

Hazel Meade writes:

I also question what you mean what you say you don't believe in bubbles.

To me, bubbles are caused by psychological feedback among investors. A bunch of people behaving irrationally together create a self-fulfilling prophecy of perpetual asset value increases. Not believing in bubbles is a bit like claiming you think investors are perfectly rational, or that herd behavior doesn't affect markets.

Scott Sumner writes:

Thomas, Good points.

Dr. Swaggington, I agree. Note however that policies encouraging housing are not the whole story. They don't have much effect on house prices in states with low barriers, like Texas.

Michael, I don't think I can fully explain the dotcom boom, but I will say that the intellectual property issue I mentioned makes such a boom more likely in tech companies than retailers or makers of cars or home appliances. Patents and copyrights are important barriers to entry.

Note that NASDAQ in back over 4100, after being around 1300 after the crash. In real terms is still less frothy than in 2000, but certainly doing better than other stocks.

PS. I hope it's clear I'm not giving investment advice, just trying to explain why some asset prices might be more volatile than others.

Scott Sumner writes:

Hazel, I certainly agree that many people are irrational. This post gives some perspective.

http://www.themoneyillusion.com/?p=695

Thomas DeMeo writes:

Scott- during the dot com bubble, there was no barrier to entry whatsoever. The need to even establish even basic business operations was perceived as unnecessary. Everyone was just trying to establish a demonstrable foothold in virtually any internet related business model, and get bought before the money ran out. Intellectual property was a trivial concern. It was actually considered stupid by some to waste too much time solving such issues.

Bubbles are when a new class of amateurs enter a market in large numbers, drawn by the expectation of easy money. So, the test should be to somehow look for a change in the quality of the market players.

Mark Bahner writes:
PS. I realize that my theory doesn't always work; there were those high Chinese stock prices in 2007, and the high Phoenix house prices in 2006.

This reminds me of a anecdote from my college days. (That's a long time ago, so my memory may be faulty.) A physics professor is explaining his grand new theory. A student points out several real-world examples that contradict the professor's theory. The professor waves off the criticism: "Reality is merely a special case, and therefore we need not consider it."

This isn't an actual criticism of anything Scott wrote...I just like funny stories.

Mark Bahner writes:

Disclaimer: I'm an environmental engineer, and therefore could conceivably benefit from a switch to taxes on pollution...which may be part of the reason I like them so much.

A shift in taxation away from business and low wage income toward environmental externalities -- CO2 emissions, congestion, antibiotic use, etc. -- and a progressive consumption tax would be part of this project.

This is good, but I strongly recommend using "real" pollutants, rather than CO2. Particulate matter (especially particulate less than 2.5 microns) is a great pollutant to tax, because it has clear adverse health effects. Nitrogen oxides are also a good pollutant to tax.

Steve Sailer writes:

Scott writes:

"I realize that my theory doesn't always work; there were ... high Phoenix house prices in 2006."

Actually, your theory works very well in this example: the bubble in Phoenix, Las Vegas, and California's Inland Empire was spillover from the huge increase in the value of coastal California property.

I wrote a short story in 2008 explaining the precise mechanisms by which the enormous cost of land in Los Angeles drove distant exurbs into a bubble and bust. You may find it amusing:

http://isteve.blogspot.com/2010/03/unreal-estate.html

[duplicated comment removed--Econlib Ed.]

Steve Sailer writes:

Sorry about the double post. To continue ...

In an otherwise excellent comment, Michael makes one mistake:

"California has an extreme regulatory climate where it takes 5 years or so to move raw land to a lot which can be built upon (and it has nothing to do with the "coast", as the bubble, and subsequent drop in price was by far most severe in the interior)."

No, the mechanism is that when the subprime bubble got so ridiculous that a 500 square foot house in Compton (about 10 miles from the coast) sold for $350,000 around 2006, the resident had to move somewhere, which was typically inland: the Inland Empire, the High Desert, Las Vegas, or Phoenix, most often.

These ex-coastal Californians had a lot of money all of a sudden, but environmental regulations in these regions meant that there was a multi-year lag. before new housing developments were finished. Around 2007, lots of new exurban housing within 500 miles of Los Angeles started to finally come on line, increasing supply and lowering market price.

Simultaneously, the folly of investing in exurbs filling up with not just one family from, for example, Compton but many started to become clear. In my short story "Unreal Estate," a speculator in SoCal's high desert laments in May 2007:

"Look at this neighborhood,” he says, his dismissive gesture taking in the empty malt liquor bottles on the curb, the wheelless car jacked up on a brown front lawn, and the knots of sullen youths playing hip-hop and reggaeton on boomboxes. 'All these speculators buy houses, hit a little bump in the road, need some cash, then start renting them out to lowlifes to get by until they can cash in. Property values drop like a rock. It would be no problem if just one investor did that, but when all these speculator jerks do it, the whole ‘hood is hosed.'"

Steve Sailer writes:

Scott asks:

"Were buyers "rational" in expecting the high prices in Florida, Arizona and Nevada to persist?"

The Sand State subprime boom was very much a bet on the ability of the rapidly growing Hispanic population of those states to be able to pay back huge mortgage obligations, either by earning a lot of money themselves or by creating desirable neighborhoods that future buyers would want to pay lots of money to live in.

The single most important businessman in inflating the housing bubble, Angelo Mozilo, CEO of Countrywide Financial, gave numerous speeches and interviews framing Countrywide's strategy as a bet on the credit-worthiness of minorities, especially Hispanics, whom as a Sicilian-American he identified with as another discriminated-against immigrant group:

http://www.vdare.com/articles/countrywides-angelo-mozilo-he-warned-us-but-washington-didnt-want-to-know

Mozilo and Henry Cisneros of Countrywide's Board implied that anybody who didn't think Hispanics were a good bet was racist. In modern America, that's an excellent ploy for shutting down rational thought.

Scott Sumner writes:

Thomas, If you tried counterfeiting Microsoft stock back in 1999 you'd have quickly discovered that there were very real barriers to entry.

Steve, I've done blog posts where I argue that hispanic immigration played a role in the housing boom. And of course the government began cracking down on immigration in 2006, which dramatically lowered estimates of future population growth in the sand states. That's where housing prices fell first. Then when the entire economy tanked, house prices fell all across the country (2008-09) for essentially unrelated reasons. People assumed that there was one giant housing crash, whereas there were actually two unrelated housing crashes, one after the other.

Of course this theory is a bit too neat, and I don't doubt it is an oversimplification.

Steve Sailer writes:

Right, the Sand State housing crash that began early in 2007 was the proximate cause of the financial meltdown of 2008 (in 2008, about 7/8ths of the national decline in home values were in CA, AZ, NV, and FL) that plunged the whole country into deep trouble in 2009.

Hispanic immigration in the 2000s was a giant Ponzi scheme that inflated the housing market in the mid-2000s in the Sand States before collapsing. But, diversity is our strength and all that, so the causes of the Recent Unpleasantness are little discussed.

Steve Sailer writes:

Here's a fascinating paper:

Mortgage Default by 2009: Effects of Race, Ethnicity and Economic Standing During the Boom Years

Heather Luea
Vanderbilt University

Adam Reichenberger
Bureau of Labor Statistics

Tracy Turner
Kansas State University

"Abstract: This paper examines the determinants of 2009 mortgage delinquency by race and ethnicity using new household-level data on mortgage distress from the Panel Study of Income Dynamics. Controlling for homeowner and loan characteristics as well as residence in a nonrecourse state, we find startling differences in mortgage delinquency rates that cannot be explained by observables. The unexplained black/white gap corresponds to a 44% higher likelihood that black homeowners will be delinquent on their mortgages relative to non-Hispanic white homeowners. The unexplained difference in Hispanic mortgage delinquency relative to non-Hispanic white homeowners is even greater, at double the black/white delinquency gap.

"... The economic decline that began in 2007 was preceded by nearly two decades of government-aided, rapidly rising homeownership rates among minority households (Bostic and Lee, 2007). Given this and the severity of the recent economic crisis, it is important to understand the extent to which minority households have weathered the crisis as well as non-Hispanic white households, all else equal. Indeed, the recent and historical role played by the US government and nonprofit agencies in boosting access to homeownership by underrepresented groups makes understanding these groups’ outcomes particularly relevant.4

"Footnote 4: As recently as June 2002, President Bush announced a goal of closing the homeownership gap for minority households by 5.5 million households by the end of 2010 through innovatiosn such as zero-down-payment loans. That administration's efforts followed more than a decade of housing market interventions, including President Clinton’s National Homeownership Strategy, a trillion dollar commitment by Fannie Mae, the Campaign for Homeownership of the Neighborhood Reinvestment Corporation, and expanded lending to low-income and minority households in part as a result of the implications of the Community Reinvestment Act (Turner and Smith, 2009).

"... As a preview of our findings, we find that black and Hispanic households that own their housing in 2005 are significantly more likely to become delinquent on their home loans by 2009 than non-Hispanic white homeowners. We find an unconditional, weighted likelihood of delinquency of 11.3%, 16% and 3.4% for black, Hispanic, and non-Hispanic white homeowners, respectively, making black homeowners 7.9 and Hispanic homeowners 12.6 percentage points more likely to be delinquent than non-Hispanic white homeowners."

Let's break those delinquency-by-2009 rates out:

Whites: 3.4%
Blacks: 11.3% (3.3X the white rate)
Hispanics: 16.0% (4.7X the white rate)

http://isteve.blogspot.com/2013/03/hispanics-delinquent-on-mortgages-47.html

Thomas DeMeo writes:

Scott Sumner writes:

"Thomas, If you tried counterfeiting Microsoft stock back in 1999 you'd have quickly discovered that there were very real barriers to entry."

Are you saying that Microsoft vigorously defended its markets and intellectual property? Yes, they did. So I guess that in a strict literal sense that counts as a barrier, but that had little or no effect on the avalanche of loopy internet startups we saw at the time. I worked for a couple of them. Those types of obstacles are there at some level all the time in every industry.

Microsoft was defending it's core, and famously failed to see where things were going. So yes, they squished WordPerfect, but that wasn't where things were going any more, so it had little impact.

Scott Sumner writes:

Steve, One issue that needs to be considered is that housing prices crashed in America, but not Australia, New Zealand, Britain, Canada, etc., despite similar price increases in those countries.

In my view the financial crisis had two causes, the decline in house prices, especially in the states you mention, and also the sharp fall in NGDP in 2008. Without the second factor both the financial crisis and the recession would have been far milder. Most bank failures were due to bad business loans, not bad mortgages. Falling NGDP also tanked asset prices, which hurt highly leveraged banks like Lehman.

Sherparick writes:

I think you raise a good point is that their is some barrier, natural or artificial, to creating more of a valued asset. I think that is where a financial bubble starts. But as the price of the asset climbs, and financial institutions become more willing to lend on its expected increase in value, then I think the information that "price" provides to potential investors becomes corrupted and EMH breaksdown. Investors become "speculators," and they become more susceptible to "this time its different" stories. This is when you enter the "boom" and "euphoria" periods of a bubble.

I note that Ivestipedia's discussion of the Dutch Tulip bubble starts out that discussion that there was a natural barrier to the production of tulip bulbs: "The vivid colors of tulips and the seven years it takes to grow them led to their increasing popularity among the Dutch in the 1600s. As demand for them grew, tulip prices rose, and professional growers became willing to pay increasingly higher prices for them. Tulip mania peaked in 1636-37, and tulip contracts were selling for more than 10-times the annual income of skilled craftsmen." http://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp

o. nate writes:

You write:
So a combination of low real interest rates caused by very weak returns on capital at the margin, and high average returns on infra-marginal capital in sectors protected by zoning and IP laws, will create "bubbles."

Great point, though you may be disappointed to hear that you are sounding a lot like Krugman:

So what's really different about America in the 21st century? The most significant answer, I’d suggest, is the growing importance of monopoly rents: profits that don’t represent returns on investment, but instead reflect the value of market dominance... Since profits are high while borrowing costs are low, why aren't we seeing a boom in business investment? ... Well, there’s no puzzle here if rising profits reflect rents, not returns on investment. A monopolist can, after all, be highly profitable yet see no good reason to expand its productive capacity.

http://www.nytimes.com/2013/06/21/opinion/krugman-profits-without-production.html

I think it's considerations like these that are motivating Larry Summers's preference for fiscal over monetary stimulus.

Steve Sailer writes:

Scott writes:

"Steve, One issue that needs to be considered is that housing prices crashed in America, but not Australia, New Zealand, Britain, Canada, etc., despite similar price increases in those countries.

"In my view the financial crisis had two causes, the decline in house prices, especially in the states you mention, and also the sharp fall in NGDP in 2008. Without the second factor both the financial crisis and the recession would have been far milder. Most bank failures were due to bad business loans, not bad mortgages. Falling NGDP also tanked asset prices, which hurt highly leveraged banks like Lehman."

Right. Giant historical events usually have multiple causes, and it's reasonable to speculate that some version of them would have happened anyway without the precise precipitating chain of events in our version of history. For example, even if the NYSE had not crashed in October 1929, there probably would have been some kind of big economic trouble in the 1930s. Or even if the Japanese had not bombed Pearl Harbor on December 7, 1941, the U.S. likely still would have gotten involved in WWII.

But those perfectly reasonable speculations shouldn't excuse us from studying precisely what did go wrong in our world. America put a lot of effort into studying what went wrong at Pearl Harbor and used the lessons to build systems to detect and deter future sneak attacks, which served well for almost 60 years. Pearl Harbor wasn't seen as the only reason why the U.S. had to fight WWII, but it was seen as a disaster that demanded and got careful thought. Similarly, if the Sand State mortgage bubble had never happened, no doubt something else would have come along to cause a downturn eventually.

But in our world, the Great Financial Crisis began on 9/15/2008 when Lehman went down due in sizable part to bad Sand State mortgages. The Sand State mortgage bubble was launched in large part by George W. Bush's "Ownership Society" initiative, specifically his 10/2002 White House Conference on Increasing Minority Homeownership where he told his federal regulators to back off on requirements for downpayments and documentation because that was discriminatory against blacks and Hispanics. Angelo Mozilo quickly followed up, offering $600 billion in minority and lower income lending in his 2/2003 Harvard address in return for less regulation of downpayments and documentation.

Bush apologized in his memoirs, but nobody else seems to remember this chain of events. The fundamental problem is that Diversity has become the state religion, so even when we have direct evidence of operators like Mozilo exploiting the religion for churn and burn profit, we don't want to think about what just happened.

Comments for this entry have been closed
Return to top