“Recession-Plagued Nation Demands New Bubble to Invest In”

The Onion, July 14, 2008.

‘When I use a word,’ Humpty Dumpty said, in a rather scornful tone,’ it means just what I choose it to mean, neither more nor less.’

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

Lewis Carroll, Through the Looking-Glass

This kind of news is hard to make up: The Dow Jones Industrial Index topped 15,000 two weeks ago, setting a new all-time high and encouraging one writer to envision a Dow of 116,200. One journalist wrote, “You know it’s a big bull market when even some of the most disliked stocks muster huge rallies.” The VIX index (the so-called “fear index) is at a five-year low point, suggesting to some observers that investors must be throwing caution to the wind. I visited Miami recently and was told that boom-like conditions had returned to the market in condos there. Housing prices have risen over 12% nationally over the past year, prompting some analysts to mark the reappearance of a housing bubble. Stock market pundits acknowledge “animal spirits” at large in the markets but argue that the bull market still has a long way to run—yet other pundits say that the bull market in commodities and bonds has ended. Funds raised through Initial Public Offerings (IPOs) are up 50% over last year. Mergers-and-acquisitions volume is also up—along with a return to lofty pricing and with prominent contests for control affirming more animal spirits (viz: the bidding war for Sprint Nextel by Softbank and Dish Network; the buyout of Dell Inc. by Michael Dell and Silver Lake Partners at $21.3 billion; US Airways combining with American Airlines; Delta Air Lines buying 49% of Virgin Atlantic; Berkshire Hathaway and 3G Partners buying H.J. Heinz for $27.3 billion). Yahoo! paid $30 million for a news aggregation cell phone app designed by a 17-year old boy. Apple, Google, and Amazon recently spent huge sums on tech acquisitions. High-yield (lower quality) lending by banks has also increased sharply, prompting the Fed to wring its hands over the possible deterioration in lending standards and controls. Research suggests that the zeal of investors to buy the high-yieldclip_image002 paper is a direct result of the financial repression by the Fed: with interest rates at all-time lows (driven by the Fed’s quantitative easing) investors are reaching into riskier segments of the investment spectrum. By printing money, the Fed produces a cycle that distorts prices and leads to bad decisions by consumers, investors, and business leaders. With a yield to maturity on 10-year Treasury bonds of 1.9 percent and consumer prices rising at about 2.2 percent, lenders to the U.S. government are accepting a negative real return.

What is weird about these conditions is that neither the U.S. nor global economies are roaring along. Expected growth in cash flows is the #1 driver of asset prices. But GDP growth in Japan and Europe is at or below zero. The U.S. is shuffling along at about 2% per year, hardly fast enough to stimulate job creation or capital spending that would justify lofty asset prices. It would seem that “the falcon cannot hear the falconer”: prices are detached from reality.

Accordingly, we’ve seen the concept of an economic “bubble” return to talk shows, market commentaries, and dinner-table conversations. This is significantly a 21st Century phenomenon. A quick check of Google NGram Viewer shows that the mentions of “market bubble” really only took off in the late 1990s and peaked in 2008.

Are we there yet?

Certainly, recent conditions warrant heightened attention by regulators and investors. But whether conditions warrant more extreme defensive actions depends on two things: a) more clarity about boom-and-bust cycles, and b) greater definition of “bubble.”

Cycles. The reality is that booms and busts occur irregularly—but there is little or nothing we can do to prevent them. Market economies don’t grow smoothly. The long-term trend is composed of cycles that oscillate between expansion and recession. Bubbles are associated with expansive episodes, though not all expansions have bubbles. The key points are that there will be another financial bubble in the United States some day and that it will be difficult for regulators to recognize, much less forestall.

In our book, The Panic of 1907, Sean Carr and I outlined[i] the attributes of market “tops” that are associated with bubbles:

  • Relatively high and rising indebtedness of households, businesses, and governments. Carmen Reinhart and Kenneth Rogoff highlighted this attribute prominently in their book, This Time Is Different.
  • Dramatic rise in prices reflected in aggressively high valuation multiples and transactions.
  • Buoyant demand for the assets: oversubscribed initial public offerings in equities, numerous participants in auctions for companies, natural resources, and real estate.
  • Optimism about the sustainability of future price increases.
  • Entry into the market by naïve, inexperienced, and unsophisticated investors. Bernard Baruch sold his stocks in early 1929 when he started receiving unsolicited stock tips from his shoeshine boy.
  • Talk of a “new paradigm” rendering long-standing investment maxims invalid. Such was the case during the Internet boom. “This time it’s different” is one of the most dangerous attitudes in investing.
  • Jumbo M&A deals and Initial Public Offerings. These deals change the competitive landscape and/or frame of reference for investors. Travelers Insurance acquired Citicorp in 1998, signaling the end of the regulatory ban on universal banking. The audacity of jumbo deals serves to reinforce “new paradigm” thinking.
  • Innovations in deal design, new securities, technology, and goods and services. Leading up to 1907 were the creation of trusts, new national consumer-branded products, and the spread of the telephone, automobile, and household electricity. Leading up to the panic of 2008 was the aggressive creation of exotic asset-backed securities. Joseph Schumpeter heavily emphasized the role of the inventor and entrepreneur in triggering new phases in economic cycles.
  • Aggressive financing. Banks lower their credit standards to the benefit of borrowers who lots of cheap credit.
  • Regulators and other watchdogs relax their monitoring of financial intermediaries and investor behavior.
  • Positive economic news. A recent stretch of growth.
  • Media hype and considerable popular interest. Rising prices, huge profits, jumbo deals, often to the benefit of Everyman and Everywoman, garner front-page stories.

Judged against these criteria, it just doesn’t seem that the U.S. or global economies are in bubble-like conditions. Sure, if current trends advance aggressively, we could be in bubble-land.

Definition. Robert Shiller defined “speculative bubble” as “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.”[ii] Shiller added, “The traditional notion of a speculative bubble is, I think, a period when investors are attracted to an investment irrationally because rising prices encourage them to expect, at some level of consciousness at least, more price increases. A feedback develops—as people become more and more attracted, there are more and more price increases. The bubble comes to an end when people no longer expect the price to increase, and so the demand falls and the market crashes.”[iii] The problem is that it is impossible to translate the textbook definitions of “bubble” into an operational or actionable concept. Peter Garber notes “bubble …is a fuzzy word filled with import but lacking a solid operational definition….if we have a serious misforecast of asset prices we might then say that there is a bubble. This is no more than saying that there is something happening that we cannot explain, which we normally call a random disturbance. In asset pricing studies, we give it a name—bubble—and appeal to unverifiable psychological stories.”[iv] Some economists, such as Allan Meltzer[v] and Olivier Blanchard[vi], allow that some deviations from fundamentals may be rational, as for instance, where a market price depends on its own expected rate of change. That is, perhaps the changes in asset prices will be self-fulfilling. Meltzer has written, “Bubble phenomena are what remain unexplained by [some rational hypothesis]. In this sense, bubbles are a name assigned to phenomena that may be explained by an alternative hypothesis….”bubble” is a name we assign to events that we cannot explain with standard hypotheses.”[vii]

At the core of the concept of a bubble is a sense of psychological instability. Alan Greenspan, chairman of the U.S. Federal Reserve Board expressed the concern on December 5, 1996 coined the phrase, “irrational exuberance” in suggesting that prices in the stock market might not be reflecting economic fundamentals.[viii] After the stock market had risen considerably further, on February 23, 1999, Greenspan was asked whether he still thought the market displayed irrational exuberance. He replied that irrationality is “something you can only know after the fact.”

The basic problem is that not all explosive movements in prices are bubbles, manias, or evidence of irrational exuberance. As Alan Meltzer has pointed out, asset prices exploded in Germany in the 1920s in response to the Reichsbank’s monetary expansion.[ix] Popular usage of “bubble” has been sloppy and perhaps self-serving. Humpty-Dumpty is instructive: “bubble” probably means whatever the writer or speaker wants it to mean.


It may be true that The Onion got it right, that investors are starting to build a new bubble. Certainly, that could be the consequence of a very expansive monetary policy. But I think that it’s just too early to tell and the whole concept of a “bubble” remains fuzzy. However, anxieties aren’t unwarranted. Maladroit unwinding of the Fed’s program of quantitative easing could trigger a sharp reversal of investor expectations, which might look like the bursting of a bubble.

[i] We developed this list from field observation and Shiller (2000), Kindleberger and Aliber (2005), Lowenstein (2004), Hunter, Kaufman, and Pomerleano (2003), and Caverley (2004). Caverley (page 13) offers his own abbreviated list. See the bibliography in Panic of 1907 for details on these sources.

[ii] Robert Shiller, Irrational Exuberance, Princeton: Princeton University Press, 2000, page xii.

[iii] Robert Shiller, “Diverse Views on Asset Bubbles,” chapter 4 in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, W. C. Hunter, G. G. Kaufman, and M. Pomerleano eds. Cambridge, MIT Press, 2003, page 35.

[iv] Peter M. Garber, Famous first Bubbles: The Fundamentals of Early Manias, Cambridge: The MIT Press, 2001, page 4.

[v] Allan H. Meltzer, “Rational and Nonrational Bubbles” Chapter 3, in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, W. C. Hunter, G . G. Kaufman, and M. Pomerleano eds. Cambridge, MIT Press, 2003.

[vi] See, for instance, Olivier Blanchard, (1979) “Speculative Bubbles, crashes and rational expectations,” Economic Letters 3, 387-389, and O. J. Blanchard and M. W. Watson, (1982) “Bubbles, rational expectations and speculative markets,” in Crisis in Economic and Financial Structure: bubbles, Bursts, and Shocks, P. Wachtel, editor (Lexington Boos, Lexington, MA).

[vii] Allan H. Meltzer, “Rational and Nonrational Bubbles” Chapter 3, in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, W. C. Hunter, G . G. Kaufman, and M. Pomerleano eds. Cambridge, MIT Press, 2003, page 24.

[viii] Alan Greenspan’s speech is worth reading in full, and may be found at http://www.federalreserve.gov/BoardDocs/speeches/1996/19961205.htm.

[ix] Allan H. Meltzer, “Rational and Nonrational Bubbles” Chapter 3, in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, W. C. Hunter, G . G. Kaufman, and M. Pomerleano eds. Cambridge, MIT Press, 2003, pages 23 and 27.