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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
• 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 –
   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
  – Historic PE 14.5 to 1, implied earnings yield 7.0
  – 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 2.0-
    3.0 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
     PE Ratio

• 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
        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
• 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
• 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
• 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 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.
    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
• 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.)
• 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
• 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
• 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

Center for Economic and Policy Research

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