On Monday, my Bloomberg View colleague Mark Gilbert explored a fretful question: Are we in the midst of yet another asset bubble? Stanley Druckenmiller, who helped George Soros “break the Bank of England” in 1992, thinks we are. In a speech earlier this year, he said he’s got the same bad feeling he had in 2004. The culprit is the same in both cases: the Fed, blowing asset bubbles, beautiful asset bubbles, with excessively loose monetary policy.
Gilbert ably summed up Druckenmiller’s remarks and the reasons to be worried about frothy asset prices, so I won’t try to replicate his fine efforts. Like Druckenmiller, I think there’s evidence that investors are “reaching for yield,” pushing into riskier investments in an attempt to reap the higher returns they got used to. Instead, I’ll focus on a different question: How much is the Federal Reserve really to blame?
It is received wisdom among many Wall Street professionals — and the majority of conservatives of my acquaintance — that the Fed’s monetary policy is capable of producing massive asset price bubbles. And it did so in the late 1990s in the stock market, then again in the housing market. Many charts have been made juxtaposing the Fed funds rate and the S&P 500 or the Case-Shiller index. I expect many more will be produced in the years to come. But I am not sold on the value of these charts, because they don’t give me a mechanism. How does mispricing a single short-term interest rate cause investors to go mad and start wildly speculating on stocks and housing loans?
I’m not arguing that there is no effect. There is obviously some, because debt markets are connected. People borrow short to lend long all the time (that’s how your bank makes money — your deposits are essentially a revolving credit line that can be withdrawn at any time). When the Fed engages in open-market operations to manage the supply of money, it changes the market’s supply of government bonds. All these things have ripple effects that are felt across many asset markets. But the case for placing most of the blame on the Fed seems to assume that these ripples are more like tidal waves, swamping any other considerations, such as whether those dot-com companies are ever going to make any more or whether people are going to be able to repay those mortgages you just underwrote. That seems extreme.
To put it another way, as I’ve remarked from time to time, if financial markets are really so stupid that keeping the Fed funds rate too low can cause the majority of investors to lose their minds and start pouring money into stuff that is unlikely to ever return their capital, much less a profit, then conservatives are wrong and free markets don’t work, and we should just abandon the whole project.
Ben Bernanke himself made this point in a 2012 speech. Of course, he would say that, wouldn’t he? But he made some other convincing points — noting, for example, that the housing bubble was international and seems to have started building in the late 1990s, when Fed policy wasn’t all that loose. Yes, Fed policy is very powerful in the global economy, and maybe (probably?) threw fuel on the fire. But is it really so powerful that it dominated loans made in other currencies whose central banks were running tighter monetary policies? This seems like a stretch.
But what’s the alternative explanation? Bernanke hinted at it in his speech: global capital flows, or what he has called the “global savings glut.” Too much money is chasing too few investments. Perhaps these flows can be increased or decreased by government policy, but they also have a strong, independent life of their own. They may get some help from the Fed and other central banks, but they don’t necessarily need it.
For now, I’ll just note that even if Bernanke is right, that still doesn’t mean that Druckenmiller should be any less worried. Two bubbles in a row is troublesome. If we’re indeed in a third, that starts looking more like a trend — and not a good one.
What it does mean, however, is that we don’t necessarily have great tools to fight an emerging trend. Blaming the government posits an easy policy solution: Stop doing the stuff that is causing the bubbles. But if an excess of global savings over global investment opportunities is the main issue, what exactly are we supposed to do to stop that? In other words, if Bernanke is right, Druckenmiller should probably be even more worried than he is.
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