Charles Davì

Asset Bubbles and Economic Activity

In Uncategorized on October 11, 2009 at 1:05 pm

Also published on the Atlantic Monthly’s Business Channel.

The internet economic debate du jour is summed up nicely by economist Paul Krugman as follows here:

why [doesn't] a housing boom — which requires shifting resources into housing — … produce the same kind of unemployment as a housing bust that shifts resources out of housing.

And here:

why … isn’t [ there ] mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

His point is, on balance, both booms and busts involve the reallocation of resources, yet only busts seem to produce mass unemployment. While Krugman and Arnold Kling* are wrapped up in a debate about how the question influences our understanding of government stimulus, I’d like to simply offer up an answer.

For any fixed amount of capital available for investment, an increase in the amount of capital allocated to one area implies that the amount of capital allocated to some other area must have decreased. In short, capital allocation with a fixed amount of capital is a zero sum game. The same is true of society’s capital. If the pie doesn’t grow, but stays fixed, and society shifts more of its capital into one area of economic activity, it necessarily implies that we have taken capital away from some other activity.

Asset bubbles, however, are, according to my theory of the world, able to temporarily increase the amount of capital society has available for investment because of the effect that asset bubbles have on the market’s expectation of incurring losses on investments tied to the bubble-asset. Some of the capital that society has available for investment is held back by the market in cash or cash-like investments, such as short term Treasuries, in order to cover potential losses that might arise from investments. Some entities, such as banks and insurers, are subject to regulations that dictate how much capital must be set aside to cover these potential losses. Other entities are free to estimate the amount of capital that needs to be held back in order to cover these losses. So, if we took a snap shot of all of society’s capital available for investment at a given point in time, some portion of that would be withheld as a loss reserve in cash or cash like investments. That means some portion of the capital available for investment isn’t really being allocated to “investments,” but being withheld to cover potential losses on bona fide investments.

Asset bubbles create value out of thin air. Price trends develop that deviate sharply from historical norms, and eventually a new, albeit temporary, norm is established. As a result, asset bubbles make the bubble-asset look like a much better investment than it will eventually turn out to be in the long term. As such, asset bubbles create capital available for investment out of thin air because they cause the market to underestimate the amount of capital that has to be set aside to cover potential losses arising from investments tied to the bubble-asset. This means that the effective pie, the portion that actually gets invested in non-cash assets, can be temporarily expanded, removing the zero sum accounting restriction, simply because less of society’s resources are used to cover losses.

When homes across the U.S. all started increasing in value more or less in tandem, home owners felt, and in fact were, richer than they were the day before. They could access the newly found equity in their home to purchase other goods, or double-down and purchase yet another home. As this process escalates and apparent price trends develop, banks feel more confident in making loans tied to housing and begin to compete for those loans. Mortgage lending, which was traditionally considered a “safe” lending business, got even more “safe” since the value of the collateral would surely continue to increase over the life of the loan. So even if the borrower lost his job or his legs, he could always sell the house to cover the loan: there will surely be plenty of equity between the face value of the loan and the price of the home upon sale. And so as lenders’ expectations of an upward trend in price becomes more entrenched, lenders become willing to lend greater amounts of money tied to real estate and can do so without subtracting from other lending activities by simply reserving less capital for losses on their real estate lending.

So what happens when bubbles pop? Once losses exceed expectations, the market is forced to reallocate its capital to cover those losses or face insolvency. If the price of the bubble-asset drops far enough, this could force fire sales outside the bubble-asset market as firms scramble to cover their liabilities. Once this happens, economic actors have less access to capital than they did before the bubble got started, leading to a sharp contraction in economic activity and concomitant upticks in unemployment.

One thing that still puzzles me is why bubbles pop when the bubble-asset isn’t usually expected to produce a cash flow. For example, capital invested in internet companies (e.g., internet stocks) should at some point generate the return that everyone was expecting. When internet startups don’t generate positive cash flows, those returns fail to materialize en mass, and that’s a clear signal to the market that its expectations were off. And so the bubble pops. But what sort of return were people expecting from housing? What was the signal that caused the bubble to pop? Clearly, defaults on bonds backed by real estate were the signal to the capital markets, but what caused the price plateau in the underlying housing market that got the defaults rolling? Was it that credit was extended to the maximum extent possible, and so no further appreciation was possible? Or was the cause psychological, a sort of vertigo price point at which both lenders and borrowers lose their nerve?

*Arnold Kling has proposed an alternate explanation involving the timing of bubbles, arguing that bubbles are gradual while busts are sudden, and that’s the cause. While shocks to expectations are generally bad for markets, I think that this explanation is intellectually unsatisfying because (i) it doesn’t explain why busts are sudden and (ii) it tacitly assumes that sudden changes create unemployment, which is probably true, but is merely descriptive and not explanatory.

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  1. Nevada Unemployment Trends – August 2009

    Nevada Unemployment Trends in Heat Map form:
    here is a map of Nevada Unemployment in August 2009 (BLS data)

    versus Nevada Unemployment Levels 1 year ago

  2. Assets in a bubble initially are cashflow positive in the initial phase. The trade finances itself, and returns are decent. By the middle of bubbles, they are cashflow negative, but earnings are strong in the rearview mirror, with decent price momentum, but low positive forward looking returns. At the end, not only is the arb negative, but agents have to pay to maintain the position. The negative carry, and the failure to be able to keep paying in is what eventually leads to the popping of a bubble.

    Or, as I have said in other places: Bubbles are primarily a financing phenomenon. Bubbles end when financing is no longer adequate to carry the assets that are bubbling.

  3. One possible theory of why bubbles burst nastily is that when the bubble begins to go bad, there is a further misallocation of resources in a vain attempt to stabilise prices; if say X has a 20% reserve against collapse, they are tempted to use too much too soon in the down move (intervening say 7% down from the top instead of 25% from the top). This temptation may be driven by the memory of some successful defensive actions before the one that fails…
    Part of this may be options-driven: say in the forex options markets there is often resistance at a significant strike price with a large open interest, but if the market eventually goes through that price then the move often goes much further and fast.
    I do believe that the real estate debacle was set up by systemic underpricing of the implied at-the-money ‘put’ granted to subprime borrowers in high loan-to-value mortgages… but this initial misallocation may have been made worse by unsuccessful attempts by the Bush Administration to avoid recession.

  4. I think the question can be reframed as why does the price stop at where it does? May be this can be answered using the classic demand/supply equilibrium construct. Either the supply expands much faster at this price (everyone will like to sell a Million $ condo in Las Vegas) or demand constricts (which may be caused in part by the credit availability theory that you mentioned). But can this be modeled with any accuracy? What do Demand and Supply curves for bubble assets look like?

    • Rajul,

      That’s an interesting point that I had actually discussed with a friend of mine. Since all it takes is for prices to plateau to get the ball rolling – many borrowers could only afford the mortgage if they could sell or refi – any temporary imbalance in the supply/demand of housing could cause the pop. If this is the case, there is probably some data out there supporting this position.

  5. Could it be that they pop because eventually the light of reality shines through.
    One holds on or buys more as long as it seems justified – but as in the real estate example – after a while the cost of carrying the asset is not justified by its expected return.
    When these suicide loans reset (2007) is was clear even to the die hard optimist that you would never be able to rent these houses for an amount close to the mortgage payment. Then everyone wanted out and this drove down the price.

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