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Financial Bubbles:
What They Are and What
Should Be Done
CEPR Basic Economics Seminar
Dean Baker
November 10, 2005
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 Aren’t Cute: How bubbles harm the
economy
• How the Fed Can Burst Bubbles
• Holding the “Experts” Accountable
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
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
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%
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 2.03.0 percent from dividends, plus minimal capital gains,
depending on growth assumptions
– Investors would receive much better returns from
government bonds
Projections If the Price to Earnings
Ratio Isn’t Constant
If the PE ratio rises, then dividend yield falls, leading to ever higher PE
Price to Earnings Ratio
700
PE Ratio
600
500
400
300
200
100
• 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
2077
2073
2069
2065
2061
2057
2053
2049
2045
2041
2037
2033
2029
2025
2021
2017
2013
2009
2005
2001
1997
0
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
The Realtor’s Fundamentals
• Population growth – it’s slower today than in prior decades
• Rising incomes – incomes grew far more rapidly in the 50’s and
60’s
• Environmental restrictions on building – the late 90’s 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)
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 didn’t 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
Bubbles and the Economy
Why They Aren’t Cute
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 don’t 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
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.
How the Fed Can Burst Bubbles
• It is the Fed’s job – Greenspan intervened
to stem the stock crash in 1987. He
intervened in the unraveling of the LongTerm 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.
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?
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 don’t do their job; why don’t
economists, financial analysts, investment managers, and policy
analysts? (“Everyone else was wrong too” doesn’t 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.)
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
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 OverValuation of the Stock Market and the Dollar,” Washington, D.C.:
Center for Economic and Policy Research
[http://www.cepr.net/publications/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.
Financial Bubbles:
What They Are and What
Should Be Done
Dean Baker
[email protected]
Center for Economic and Policy Research
www.cepr.net