Asset Bubbles: Curing Bubble Blindness

Justice Litle looks carefully at an offhand remark by Alan Greenspan that “there are a lot of local bubbles,” explains why this is a lot more important than it may first appear, and hopes that this means a future where the Fed proactively targets Asset Bubbles.

Curing Bubble Blindness

AND THE BEAT goes on: Existing home sales for April hit a record high, while home prices saw the biggest gains in over two decades.

The cover of FORTUNE features the words “REAL ESTATE GOLD RUSH” in bold caps. Meanwhile, The Washington Post reports that even Playboy Bunnies are turning in their tails for real estate licenses and one out of every four houses bought last year was, ahem, investment property (“speculative purchases” is just too crass for polite company).

As the piece de resistance, adjustable-rate and interest-only loans represented close to half of all mortgages in the second half of 2004.

Greenspan says, “At minimum, there’s a little froth in this market.” At a New York luncheon, he went on to say, “We don’t perceive there to be a national bubble, but it’s not hard to see that there are a lot of local bubbles.”

On surface inspection, there isn’t much to see in these remarks. The maestro seems to grudgingly acknowledge the housing bubble issue, now that it’s too big to be denied, while simultaneously downplaying its importance.

Dig deeper, though, and things start to look more interesting.

It wasn’t so long ago that Greenspan adamantly denied the possibility of bubbles, or at least the ability to spot them with foresight. He argued that it’s impossible to recognize a bubble before it bursts, and that even if you could recognize a bubble in the making, there’s not much to be done until it pops.

This “hindsight is 20/20” defense was used to justify the Fed’s response to the dot-com debacle, or rather, its utter lack of response. In the days of the late great tech boom, Greenspan essentially cheered on the way up and wrung his hands on the way down, waiting until the stock market imploded — to the tune of $7 trillion — before taking emergency measures.

The Fed’s long-standing bubble-blind stance was rooted in the efficient-market hypothesis, or “random walk” theory, which is dying a slow but sure death.

For many decades, academics have believed that markets are perfectly rational and accurately priced at all times, making foresight worthless and the very existence of bubbles an impossibility.

The efficient-market hypothesis is a silly and stupid belief, for a wide number of reasons; but like many other dumb ideas, it has managed to stick around and hold otherwise intelligent people in thrall.

Only in recent years has the dogma been successfully challenged on academic grounds. (Successful traders and investors, making good money for centuries, never saw reason to care about egghead theory in the first place. That would be like the bumblebees packing it in on notice of being grounded by the aerodynamics department.)

The connection between the Fed and asset prices is fairly straightforward. If asset prices are always and everywhere rational, as a dwindling band of academics believe, then the Fed does not need to target asset prices, because permanently rational pricing implies fair value at all times.

If efficient-market theory is wrong, however, and the markets are not always rational, then asset prices have the potential to get out of whack…sometimes dangerously so. In this case, the Fed needs to pay attention to asset prices and discern whether current valuations are rational or bubblelike in making their decisions.

The Fed has a fine line to walk when it comes to asset bubbles, and at least one or two groups will be upset regardless of what happens. If it looks like a bubble is developing and the Fed takes steps to curb it, both the efficient-market academics and the die-hard bulls will be upset.

The academics will say, “Who are you to play god with markets that we of the ivory tower have declared perfect?” Meanwhile, the goggle-eyed bulls will say, “Who are you to ruin our party when it’s just getting good?”

On the other hand, if the Fed does nothing and takes the bubble-blind stance as asset prices go vertical, the realists and inflation hawks will start jumping up and down, shouting, “Hey, you money-pumping nimrods, it’s not your job to be popular…You’re supposed to take away the punch bowl, not spike it!”

So should the Fed target asset prices or not? In our leverage-driven, fiat-money system, is it the chairman’s job to target bubbles in their infancy (especially ones born of their own monetary policy creation)? Noted Fed watcher and financial journalist Martin Mayer, in his book The Fed, thinks they should:

“The theoreticians have been arguing for several years about the extent to which central banks should pay attention to asset prices. The discussion is being conducted on a very high level, with very tenuous links to reality. But the truth of the matter is probably that asset prices are at the heart of what a central bank does as we open the new millennium. ‘Monetary policy,’ Charles Goodhart told a Levy Institute conference in 1999, ‘has its real effects by its influence on asset prices. But the effect of interest rates on asset prices is the result of a whole chain of attitudes, and the relations of interest rates to asset prices are highly uncertain.'”

Asset Bubbles: Greenspan Shouting from the Rooftops

So back to the maestro’s offhand remarks: When Greenspan says, “It’s not hard to see that there are a lot of local bubbles” in the housing market, it’s the equivalent of a lesser official shouting from the rooftops.

By acknowledging the existence of asset bubbles (even if they are dismissed as local), the maestro has reversed tack from his previous bubble-blind stance and subtly acknowledged the Fed’s need to take asset prices into future account…or at least the possibility of such.  

From here, it’s not a far stretch to imagine a future Fed targeting asset bubbles proactively.

The Fed may not be comfortable making this shift from bubble blindness to bubble awareness, but it really doesn’t have much choice.

Through the rampant asset appreciation of the U.S. housing market, funded by a tidal wave of high-risk mortgage loans and growing speculative abandon, it has become abundantly clear to the rational world — sans academics, perhaps — that monetary policy is deeply intertwined with real asset values at the extremes. 

The good news is that when it comes to proactively nipping bubbles in the bud, the Federal Reserve has a few precise tools at its disposal in addition to the blunt hammer of interest rates.

In the late ’90s, when the dot-com frenzy was getting out of hand, Greenspan could have sent a strong signal by raising margin requirements on equities.

This would have slowed things down a bit, acting as a psychological brake, as well as a leverage reducer. The bulls would have bellowed, but the following multitrillion-dollar debacle might have been far less painful as a result of Fed foresight.

More recently, a proactive Fed could have taken early steps to reign in loony mortgage lenders.

If insanely greedy banks have so little common sense as to hand out zero-down, adjustable-rate, interest-only loans to speculative buyers already leveraged past their eyeballs, the Fed could surely provide some common sense on their behalf by adding a mandatory “sanity clause” to all lending agreements. Sadly, this is asking too much.

In acknowledging that bubbles exist (in his roundabout, ineffectual way), Greenspan has cleared a path for his replacement. That isn’t much, but at least it is something. Slowly the Fed is being brought around to the notion that markets are not perfect, or even close to perfect, except in their uncanny ability to destabilize each other and their need to be approached with common sense as well as academic theory.

This means a more proactive policy, and a chairman willing to take unpopular action much earlier in the cycle…ideally when “irrational exuberance” is first confirmed, rather than long after it has clearly run amok.

The longtime appeaser Greenspan, on his way out the door, isn’t up for the task. Hopefully, his successor will be.

Regards,
Justice Litle,
Contributor, Whiskey & Gunpowder,
Editor, Outstanding Investments
May 26, 2005