Financial Bubbles: What They Are and What Should Be Done CEPR Basic Economics Seminar Dean Baker November 10, 2005

1
Financial Bubbles What They Are and What Should
Be DoneCEPR Basic Economics Seminar Dean
BakerNovember 10, 2005
2
Financial Bubbles What They Are and What Should
Be Done

• The Nineties Stock Bubble The Secrets of Simple
  Arithmetic
• The Housing Bubble You can always live in an
  overpriced house
• Bubbles Arent Cute How bubbles harm the
  economy
• How the Fed Can Burst Bubbles
• Holding the Experts Accountable

3
The Simple Arithmetic of the Stock Bubble

• Short-term (1 day to 5 year) stock returns are
  unpredictable, largely random
• Long-term stock returns can be predicted based on
  profit growth and PE ratios
• Forecasters (CBO, OMB, private forecasters)
  routinely make profit growth projections,
  therefore it is very simple to derive stock
  return projections
• Stock returns have two components capital gains
  (the rise in share price) and dividend payouts
  (including share buybacks)
• Stock returns capital gains dividend payouts
  DEFINITIONAL TRUTH

4
Projecting Stock Returns

• Assume PE is constant through time then capital
  gains equal the rate of growth in profit
• Dividend payouts average 60 of profits limited
  by the need for reinvestment
• Dividend yields 60 of earnings yield (inverse
  of PE ratio)
• Therefore, stock returns profit growth 60 of
  earnings yield

5
Stock Returns Normal and Bubble Years

• Normal
• Profit growth 3.0 a year, capital gains 3.0 a
  year
• Historic PE 14.5 to 1, implied earnings yield 7.0
  percent
• Dividend yield 60 of 7.0 4.2
• Stock return 3.0 capital gains 4.2 dividend
  yield 7.2

6
Stock Returns Normal and Bubble Years

• Normal (7.2)
• Nineties Bubble Years
• PE crossed 20 in 1996 and 30 in 1999, so earnings
  yield was under 5 after 1996 and close to 3.0
  in 1999
• The dividend yield fell from 3.0 in 1996 (60 of
  5) to less than 2 in 1999
• Normal profit growth was 3.0 but 1996-2000 were
  near cyclical peaks. CBO projected NEGATIVE real
  profit growth from 1999 to 2019
• In bubble years, projected stock returns would
  have been 2.0-3.0 percent from dividends, plus
  minimal capital gains, depending on growth
  assumptions
• Investors would receive much better returns from
  government bonds

7
Projections If the Price to Earnings Ratio Isnt
Constant
If the PE ratio rises, then dividend yield falls,
leading to ever higher PE

• If the PE falls, then capital gains are negative
  and returns are far worse than if PE stays
  constant
• A high PE guarantees low returns unless profit
  growth goes through the roof

8
How to Recognize a Housing Bubble

• In the long run, house prices nationally have
  followed inflation
• In the long run, house prices have risen more or
  less with rents (same market)

• Unless some fundamental factor has changed, then
  the run-up since 1997 is a bubble

9
The Realtors Fundamentals

• Population growth its slower today than in
  prior decades
• Rising incomes incomes grew far more rapidly in
  the 50s and 60s
• Environmental restrictions on building the late
  90s were not the heyday of environmentalism
  (Republican takeover of Congress and state
  houses)
• Limited supply of land land has always been
  limited what happened to Internet removing
  restrictions of time and space?
• Low interest rates if low interest rates
  explain the run-up, then house prices will
  plummet when interest rates return to normal
• It is interesting to note that the fundamentals
  just started to drive up house prices at the same
  time the stock bubble was pushing up stock
  prices. (Stock wealth can lead to higher real
  estate prices, just as in Japan
  in the 80s)

10
Bubbles National and Local

• Housing markets are local, but there are common
  factors
• The collapse of the bubble will not hit every
  market equally (the collapse of the stock bubble
  didnt hit every stock equally) but virtually all
  markets are likely to see price declines
• Higher interest rates will likely lead to a
  collapse, but overbuilding will eventually
  saturate the market, even without an increase in
  interest rates

11
Bubbles and the Economy

• Why They Arent Cute

12
How the Stock Bubble Harmed the Economy

• Misdirected investment companies with no real
  future get billions to invest
• Inflated stock prices conceal accounting fraud
  (e.g., WorldCom, Enron, Global Crossing)
• Consumer wealth effect people spend based on
  stock wealth that is not there they dont have
  retirement savings when needed
• Under-funded pension funds (e.g., Delphi, United,
  Northwestern, etc.) as pension fund managers had
  assumed bubble would last
• Collapse leads to a demand gap (a.k.a. recession)
  that is difficult to counteract

13
How the Housing Bubble Harms the Economy

• Overbuilding in housing due to bubble inflated
  prices, resources that could have been better
  invested elsewhere are spent constructing big
  homes
• Consumer wealth effect people spend based on
  housing wealth that is not there they do not
  have retirement savings when needed
• Possible financial panic when bubble bursts,
  secondary mortgage market (Fannie Mae and Freddie
  Mac) could be in danger
• Collapse leads to a demand gap (a.k.a. recession)
  that is difficult to counteract.

14
How the Fed Can Burst Bubbles

• It is the Feds job Greenspan intervened to
  stem the stock crash in 1987. He intervened in
  the unraveling of the Long-Term Capital Hedge
  Fund in 1998. The stock and housing bubbles have
  gar more impact on the economy than either of
  these events
• The Fed has regulatory tools margin
  requirements on stocks, lending soundness on
  housing.
• Interest rates higher interest rates can burst
  bubbles.

15
Fed Talk (or Treasury Talk)The Best Weapon
Against Financial Bubbles

• The Fed chair and the Treasury Secretary have
  enormous audiences for their pronouncements
• If either of them clearly laid out the rationale
  for a stock or housing bubble (e.g., showed my
  charts) then every investment manager and
  financial advisor in the country would have to be
  familiar with the argument.
• Any investment manager or financial advisor who
  simply ignored these arguments would risk being
  fired and possibly sued for negligence.
• Talk is cheap why not do it?

16
Holding the Experts Accountable

• It was possible (in fact easy) for any
  professional analyst to recognize the stock
  bubble
• It is possible (in fact easy) for any
  professional to recognize the housing bubble.
• Custodians get fired when they dont do their
  job why dont economists, financial analysts,
  investment managers, and policy analysts?
  (Everyone else was wrong too doesnt cut it.)
• The Congressional Budget Office and Social
  Security Administration have consistently made
  stock return projections for Social Security
  privatization that they cannot support.
• CBO over-estimated projected revenues in 2000 by
  close to 1 trillion over a ten year time frame
  (0.8 of GDP) because it assumed that the stock
  bubble would persist indefinitely. (No
  one was fired.)

17
Conclusions

• It is possible to recognize bubbles financial
  markets are not that mysterious
• Financial bubbles cause enormous economic damage
  far more than modest increases in the inflation
  rate
• The Fed and Treasury can and should act to
  counteract bubbles
• Economists, business, and policy professionals
  who cannot see financial bubbles should find
  another line of work

18
Reading List

• Baker, D. and D. Rosnick, 2005. Will a Bursting
  Bubble Trouble Bernanke? The Evidence for a
  Housing Bubble Washington, D.C. Center for
  Economic and Policy Research http//www.cepr.net/
  publications/housing_bubble_2005_11.pdf.
• Baker, D. 2002. The Run-Up in Home Prices Is It
  Real or Is It Another Bubble? Washington, D.C.
  Center for Economic and Policy Research
  http//www.cepr.net/publications/housing_2002_08.
  pdf.
• Baker, D. 2000. Double Bubble The Implications
  of the Over-Valuation of the Stock Market and the
  Dollar, Washington, D.C. Center for Economic
  and Policy Research http//www.cepr.net/publicati
  ons/double_bubble.pdf.
• Kindleburger, C. 2000. Manias, Panics, and
  Crashes A History of Financial Crises. New York
  John Wiley and Sons.
• Shiller, R. 2005. Irrational Exuberance,
  Princeton, NJ Princeton University Press.

19
Financial Bubbles What They Are and What Should
Be DoneDean Bakerbaker_at_cepr.netCenter for
Economic and Policy Researchwww.cepr.net