July 16 , 2003
In my last column, I suggested that real estate values were
not reflecting an asset "bubble" of emotionally driven price gains
unjustified by prevailing economic conditions.
Enterprise values, which are reflected in stock prices, also are
justified by prevailing economic conditions at this time.
Technology stocks surged in the latter 1990s as households
doubled the percentage of equity assets they normally held.
That was a bubble. However, the subsequent 70 percent drop in NASDAQ prices and
a nearly 30 percent decline in the S & P index in the past three years
appear to have removed the bubble.
To be sure, investors are paying a high price for earnings
and housing, but the finance charges associated with that house purchase and the
returns on stocks relative to alternative investments, such as bonds, are
appropriate for prevailing interest rates.
At the same time, I noted that ample liquidity exists to
support excess asset valuation. (While
such excesses are necessary to create an asset bubble, it does not automatically
mean that one will develop. Government
liquidity, in the form of currency, may only be supplanting reduced bank created
liquidity if depositors lose their desire to hold bank deposits.)
Which leads us to whether bond prices have become
excessive. Did the stock bubble
shift to the bond market?
Historically, such shifting of excess valuation from one
asset class to another is highly unusual. Indeed,
the emotionally driven asset class that is bubbling up normally starves other
asset values. Thus, English land
prices were dropping as the South Seas were being bid up to ridiculous prices
per acre. These distortions in
relative asset values contribute to the subsequent economic weakness when the
Yet, there are signs that quick efforts to stem the fallout
from this bursting bubble prevented the collapse of liquidity that normally
follows. (Normally, financial
institutions are seriously harmed and depositors are fleeing, such as occurred
during the Great Depression.)
I think those aggressive policies were correct.
Why should borrowers fear the loss of loan support because the banks are
in trouble? We have seen enough
fallout from such behavior in Japan in recent years and do not need to learn a
similar lesson here.
Nevertheless, by preserving bank lending capacity, these
policies allowed some shifting in speculative behavior.
In the British Isles, speculation appears to have flowed to housing.
There, you can get a bank loan on your signature to use for a down
payment on a house that has not yet been built.
The speculator hopes that by the time the building is completed, prices
will have increased so much that the house can be sold, all debts can be paid
and a tidy profit can be earned. The
result is a building boom that greatly exceeds the growth in households to
occupy all those newly built units.
U.S. housing is not being built faster than it is being
occupied. Some apartments are being
emptied as low interest rates push monthly finance costs for home ownership
below monthly rents. This will
create some problems in apartment development, but construction already is
When prices on the ten year government bond rose so high
that yields declined to less than 3.1 percent, a new explanation was
coined…deflation. Remember, new
justifications for supporting rising asset prices is a warning that those prices
may no longer be appropriate.
Fortunately, information rapidly develops to justify or refute inflationary expectations. Rising insurance rates and higher health costs belied the discussion of deflation. A falling dollar also is incompatible with deflation.