A SYMPOSIUM OF VIEWS What About the Risk Of a Bursting Asset Bubble? he global economic policy world is in the midst of a debate over the risk of inflation, including the definition of the word “transitory.” But what about the risk of the bursting of an asset bubble? T What is surprising is the minimal amount of discussion about whether today’s so-called “era of free money” has created dangerous asset bubbles. History shows that the bursting of asset bubbles can bring nasty macroeconomic consequences. Note that in the United States alone, new corporate debt since the pandemic has skyrocket- ed. Mediocre companies have been able to buy back their stock. Wouldn’t these firms be the first to collapse in a financial panic? Then again, does the fact that the Wall Street banks are so well capitalized minimize the negative effect to the broader U.S. economy from a panic-driven mar- ket correction? In such a correction, what would be the safe haven? U.S. Treasury bonds? Gold? Cryptocurrency? Commodities in general? If the latter, wouldn’t there also be unpleasant macroeco- nomic consequences? On a scale of one to ten, more than twenty noted observers rate the risks. An 8. The Achilles heel The context has been that of admirable dedication by central bankers to delivering their economic objectives, has been over-reliance but one that has not been accompanied until recently by on the “financial asset sufficient policy effectiveness on the part of other eco- channel” as the main nomic policymakers. The Achilles heel has been the resulting and protract- transmission ed over-reliance on the “financial asset channel” as the mechanism for main transmission mechanism for macroeconomic policy macroeconomic policy to the real economy. The unintended consequences and collateral damage to the real economy. have included a major disconnect between fundamentals and market valuations (Main Street versus Wall Street), MOHAMED A. EL-ERIAN deepening asset price distortions, over-borrowing, and President, Queens’ College, Cambridge University; Chief widening resource misallocations. Economic Adviser, Allianz; and author, The Only Game in This has all been turbocharged by behavioral factors Town: Central Banks, Instability, and Avoiding the Next including an overriding investor confidence in central Collapse (Random House, 2016) banks always being the markets’ best friend—or what’s more commonly referred to as the “central bank put.” core: eight. Pockets of excessive and, in some cases, This has encouraged too many investors to embrace the irresponsible risk-taking have been fueled by years liquidity paradigm irrespective of the underlying funda- Sof ample and predictable liquidity injections by the mentals, and traders have piled on, surfing the enormous Federal Reserve and European Central Bank, the world’s liquidity wave and over-extending the risk-taking both in most systemically important central banks. scale and scope. SUMMER 2021 THE INTERNATIONAL ECONOMY 43 El-Erian, cont. The risk is not limited to the future cred- ibility of central bank policies and the possibility of unset- tling financial volatility. There is also the threat of wide- spread economic spillbacks and spillovers: to economic recoveries in the United States and Europe that need to be durable, strong, inclusive, and sustainable; and to develop- A 9. Asset prices are ing countries whose financial resilience has been eroded and policy flexibility is more limited. high by historical The solution lies in a timely rebalancing of the monetary/fiscal/structural policy mix, together with a ma- standards. jor step up in macroprudential regulation, especially that pertaining to the non-bank financial sector. JEFFREY A. FRANKEL A 3. I assign a Harpel Professor of Capital Formation and Growth, Harvard University’s Kennedy School relatively low y response: nine out of ten. probability to a Financial markets are indeed experiencing Mbubbles, spurred in part by easy money. Eventually meaningful the bubbles will end. A bursting could have severe adverse consequences for the real economy, as in 1929 or 2008; tightening of but that outcome is not guaranteed. Asset prices are high by historical standards. For monetary policy. example, Shiller’s ratio of U.S. stock prices to cyclically adjusted earnings is above 37 as of June 2021. It has been THOMAS MAYER above 30 only twice before: 1929 and 2000. Founding Director, Flossbach von Storch Research Institute, A high price-to-earnings ratio need not imply that and former Chief Economist, Deutsche Bank Group prices have overshot the present discounted value of fu- ture earnings, particularly during a time of innovation. But y answer to this question is: three. investors are innovating egregious bubble behavior. In his classic book on bubbles (Famous First Consider four recent examples: MBubbles: The Fundamentals of Early Manias, n Cryptocurrencies. Bitcoin’s price surged six-fold from MIT Press, 2000), Peter Garber wrote: “…‘bubble’ char- October 2020 to April 2021. acterizations should be a last resort because they are non-explanations of events, merely a name that we attach n The GameStop bubble. The video-game retailer’s stock to a financial phenomenon that we have not invested suffi- price increased eighteen-fold in January 2021. ciently in understanding.” n The entire phenomenon of NFTs (non-fungible tokens). So what is the phenomenon in financial markets that n The boom in SPACs (special purpose acquisition com- many call a “bubble” today? My understanding is that it panies). Their very definition calls to mind a notorious is the result of a monetary policy, prevalent in almost all 1720 company prospectus in London’s South Seas bub- industrial countries, that has driven interest rates to his- ble: “an undertaking of great advantage; but nobody to torical lows, and in the course of the Covid-19 pandemic know what it is.” induced the creation of a monetary overhang of a size pre- viously only seen in times of war. Low interest rates raise asset valuations while excess cash balances induce port- folio reallocations towards other financial and real assets. This phenomenon will only disappear when central banks put their policy in reverse gear. But since they have become prisoners of fiscal policymakers and financial markets, I assign a relatively low probability to a mean- ingful tightening of monetary policy. 44 THE INTERNATIONAL ECONOMY SUMMER 2021 A 7. I’m watching U.S. housing markets. A 2. Asset prices remain volatile and difficult to predict. ADAM S. POSEN President, Peterson Institute for International Economics oncern about a bubble should be driven by both how likely is a bubble underway, and how likely is it that JOSEPH E. GAGNON Ca bubble in that particular asset class or sector will Senior Fellow, Peterson Institute for International Economics have destructive effects (through distortion or collapse). Scale of the overvaluation, of the sector or assets involved, y concern about asset bubbles is two on a scale or of average people’s exposure can contribute to the im- from one to ten. pact of a bubble, but these are not sufficient statistics for M A bubble exists when the price of an asset predicting harm, and sometimes are quite misleading. greatly exceeds its fundamental value. That is not the case Equity price bubbles, for example, rarely have persistent at present for any of the main asset classes: bonds, equity, macroeconomic effects. and real estate. All of these assets are expensive by histor- What matters most is the connectedness of the bub- ical standards, as one would expect when interest rates are blelicious asset class and the leverage of the investors in near zero. Future rents, profits, and coupon payments are it. As a result, the simple rule of thumb for when pub- discounted at a low rate. Nevertheless, asset prices remain lic policy should be concerned about a bubble is when it volatile and difficult to predict. either involves residential real estate across a large part Aging work forces, declining population growth, of the economy or the systemically important banking in- and weak productivity growth have pushed equilibrium stitutions. Large-scale housing price bubbles are almost real interest rates to record low levels. We may be near sufficient to predict serious harms, as are over-leveraged the trough and rates may gradually rise from here, but banking systems. Absent either, it is rare that bubbles do the process will continue to be slow and we are not likely much harm. to return to the high real rates of the 1980s. Population So, I currently am at a seven out of ten in concern growth, at least, will remain low. on the lookout to raise my alarm because of recent de- When combined with ultra-low inflation, low equilib- velopments in U.S. housing markets. At the start of 2020, rium real rates keep economies at or near the zero lower prior to the pandemic, I would have given it a 4, since the bound on interest rates, with persistent excess unemploy- bubbles at the time—and most of the ones since—have ment. Fiscal policy can help push economies away from been in assets which don’t matter. The resilience of the the lower bound, but the best response is to moderately core U.S. banking system to the pandemic shock of spring raise central bank inflation targets to 3 or 4 percent. 2020 and to the Archegos collapse this year vindicates the capital requirements and stress tests of today, and there- fore reassures me. But widespread housing price bubbles do almost always mean trouble. SUMMER 2021 THE INTERNATIONAL ECONOMY 45 A 6 or 7. The situation is worrisome. A 9. I am very concerned. ROBERT SHAPIRO Chairman, Sonecon, and former U.S. Under Secretary of Commerce for Economic Affairs es, the possibility of asset bubbles bursting is wor- risome—on a scale of one to ten, I’m a six or sev- Yen.