I will not explain in this post why Central Banks actually cannot keep the nominal rate of interest below the natural rate (also called the Wicksellian rate) for a longer period without causing rising inflation, and eventually hyperinflation.
Rather I will focus in this post on the idea of how Central Bankers are supposedly creating new ‘bubbles’.
For this purpose, lets look at how Robert Shiller defines a ‘bubble’. We can rightly assume that he is actually an expert on this topic: Not only for receiving the Nobel Prize for his work on how asset market might indeed sometimes display signs of irrationality, but also for actually correctly identifying both the ‘Dot-Com bubble’ of the early 2000s and the ‘Housing Bubble’ afterwards.
In this post, he gives his formal definition of a bubble (http://www.project-syndicate.org/commentary/the-never-ending-struggle-with-speculative-bubbles-by-robert-j--shiller#Pf4GRqVkxuXi1LYa.99):
In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”
So here is my question: Has there been a large degree of enthusiasm or overconfidence in the economy over the last couple of years?
I don’t think so! With unemployment in the Eurozone being above 12%, with nominal GDP below its value in 2007, with Europe’s economic performance now being worse than during the Great Depression in the 1930s, with record-low inflation levels, with basically no signs of recovery, I really do not see an economic environment prone to asset bubbles (or am I missing something?).
Of course, all else equal, lower interest rates by Central Banks imply an increase in asset prices. But this is SUPPOSED to happen. One of the channels of monetary policy is the wealth effect (it is, however, by far not the most important channel!).
Central Banks can affect a variety of asset prices (even at the Zero-lower bound). Higher stock markets and housing prices imply that consumers are wealthier and they will thus increase consumption.
Higher asset prices as a result of lower interest rates, however, do by no means indicate the existence of a bubble! Remember that the fundamental value of a stock is simply the present value of all expected future dividends. A lower (real) interest rate thus implies that all expected future dividends are discounted by less, thus raising the present value of the stock. All else equal, lowering the interest will thus increase stock prices (and this has nothing to do at all with bubbles!) whereas increasing the interest rate will depress the stock market.
Similarly, the ‘user cost’ of housing decreases when the (real) rate of interest falls (that is because the real rate of interest represents the opportunity cost to the house owner). A lower user cost means higher housing demand. With the stock of housing being fixed in the short-run, higher demand implies higher housing prices. All else equal, lowering the rate of interest will thus increase the price of housing (conversely, increasing the rate of interest will decrease the price of housing).
Asset prices such as stocks, bonds, and also houses thus naturally move in the opposite direction as changes in the real interest rate. Lower interest rates thus will increase prices for a variety of assets, but this does not reflect ‘bubbly behavior’ in any way!
Anyone putting forward the idea that low interest rates cause bubbles, such as the author of this article (in German: http://www.spiegel.de/wirtschaft/soziales/notenbanken-henrik-mueller-ueber-die-angst-vor-der-dauerkrise-a-936679.html), must really do the following things:
First, such a person has to put forward an economic model that can explain how bubbles supposedly can be created in an economic environment characterized by low-interest rates (and thus tight money), low economic growth, low confidence, low inflation, and pessimistic expectations about the future.
Second, this person actually has to provide some reasonable empirical evidence that assets are overvalued and that prices have significantly diverged from fundamentals.
So how does it look like when one actually looks at the numbers? Is there any evidence of a potential housing bubble in Germany?
All the following graphs are from the Economist’s house price index, available here:
Germany – nominal house prices
Real house prices
House prices against average income
Note also that all countries that experienced a so-called housing bubble over the last couple of years actually were huge net importers of capital (Spain, Ireland, U.S., etc.). I have explained in an earlier post how Germany has actually been running persistent account surpluses for many years now. Germany is thus a net exporter of capital, again indicating that the fear of excessive inflows of foreign capital fueling a domestic housing bubble cannot be confirmed by the data.
So what about the stock market?
In recent months we have repeatedly been warned that the German DAX is at all-time high and might thus soon drop significantly.
My response to that kind of nonsense is that these doomsayers don’t really know what they are talking about. Stock markets are nominal indices (exactly as nominal GDP). We expect the DAX to be higher today than 20 years ago just as German GDP today is much higher than 20 years. Comparing the nominal value of the DAX today with the nominal value of the DAX in the past and concluding that there is a bubble based on this observation is meaningless!
One should rather focus on the Price-earnings (PE) ratio of the DAX to evaluate whether it might be under- or overvalued. The following chart clearly illustrates that the DAX as of today is clearly very cheap in comparison with historical values, despite being at an all-time high (in nominal terms)! The PE ratio is still fairly low and clearly below average when looking at the last 30 years. It is not unreasonable to assume that in the long-run the PE ratio will return to its historical mean. Based on mean-reversion, we should thus expect the PE ratio to increase over the next couple of years. This can only happen in two ways. With earnings per share staying constant, the PE ratio can only rise if the value of the shares increases even further, implying an even higher value of the DAX! Alternatively, the PE ratio could fall with earnings per share decreasing (this could happen if economic conditions deteriorate again).
It should be clear that the DAX is by no means overvalued when evaluated against historical values of the PE ratio. The idea of a bubble thus seems to be more than farfetched.
For a very contrarian view to mine read Roubini (in my opinion nonsense though!): http://www.project-syndicate.org/commentary/nouriel-roubini-warns-that-policymmakers-are-powerless-to-rein-in-frothy-housing-markets-around-the-world
He believes that there are currently signs of housing bubbles everywhere:
Now, five years later, signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.
Finally, look at the next two charts. The following is showing a nice bubble, right? Notice the huge increase followed by the subsequent decline?
We know that stocks actually behave very similar to random walks (that’s why future stock prices are unpredictable). Compare the random walk above with the stock chart of McDonald’s.
If everyone thinks that something is a bubble, there is about a 99.99% chance that it’s actually not a bubble! If, on the other hand, some unusual asset increases SIGNIFICANTLY (let’s just say Dutch Tulips, or stocks of Internet companies that do not yet produce anything, have no business model, etc.), and EVERYONE strongly beliefs that all of the change in price is related to fundamentals, then there is much more reason to actually be concerned!