Managing Bubbles The Scalextric Trap Guy Lion December 2008
Introduction <ul><li>The current housing, banking, finance, and credit crises resulted from the bursting of the housing bubble. </li></ul><ul><li>This presentation explores the feasibility of preempting asset bubbles (stocks and residential real estate) while managing the main Fed targets (inflation, sustainable GDP growth). </li></ul><ul><li>It also explores the possibility of adding other laudable policy goals to the Fed’s responsibilities. </li></ul>
Calibrating the Bubbles <ul><li>We did so across the two Fed targets (inflation, GDP growth) and two assets (stocks and real estate) from the 1st quarter of 1979 to the 3d quarter of 2008. </li></ul><ul><li>Generally, a variable was bubbly when it stood at one full standard deviation over the historical average over reviewed period. And, it was receding when it was a standard deviation below its historical average. </li></ul>
Tweaking bubble calibration (calculating averages and standard deviations) <ul><li>Inflation . We started history in 1986 Q2 to avoid most of the Volcker years with unprecedented inflation level and volatility. </li></ul><ul><li>Home price . We cut off the history at 2002 Q1 to avoid the bubble that also had unprecedented price levels and volatility. As a result our home price indicator average was lower and its volatility was several times lower (arguably too low). We thus, defined a bubble as two standard deviation above the average. We kept a receding home price indicator as one standard deviation below average. </li></ul><ul><li>The above cut offs were just to measure the average and standard deviation for each variable. But, we applied the resulting bubble benchmarks to the entire period (1979 1Q – 2008 3Q). </li></ul>
Home price variable <ul><li>Capturing nationwide home price bubbles over the reviewed period (79 – 08) is not evident. Affordability measures did not work over this period because they don’t distinguish between periods when mortgage financing was constrained (Volcker years) or not (Greenspan years). </li></ul><ul><li>Instead, we used Median Home Price/Median Family Income. This valuation ratio was amazingly steady at around 2.6 times until the onset of the current housing bubble. This was true even during the volatile Volcker years. </li></ul>
Stock price variable <ul><li>We used total domestic stock market cap divided by GDP. This indicator is less volatile than the P/E ratio that bounces around because of underlying volatility in both its numerator and denominator. </li></ul>
The benchmarks Benchmarks highlighted in red denotes bubbles. The ones highlighted in green denote a variable is receding (opposite of bubble). As an example, yearly inflation is “bubbly” when the CPI has increased by more than 4.2% over past 4 quarters. Inflation is deemed low when it was less than 2%.
Correlation matrix Here is the quandary, Inflation and GDP growth are already negatively correlated (periods of stagflation, etc…) making monetary policy challenging. But, the assets (stocks and real estate) are quite strongly uncorrelated with inflation. And, have near zero correlation with GDP growth. If the Fed was to focus at all times on all 4 objectives, it would constantly hit contradicting policy situations with at least 2 of the 4 objectives.
Correlation – visual representation - the early Volcker years - This shows just the beginning of the reviewed period covering the early Volcker years. This table shows from left-to-right first the traditional Fed targets: yearly inflation and quarterly GDP growth; and next the asset price indicators: home price indicator (Home price/Family income), and stock price indicator (stock market cap/GDP). The red cells are the “bubbly” ones, the green ones are the receding ones as defined earlier. This short slice of history highlights the strong negative correlation between inflation levels (bubbly red) and stock levels (receding green).
Correlation - visual representation – - the whole period - Please note: First, when the assets (stocks, real estate) are bubbly (red), the Fed targets (inflation, GDP) are not (white or green) and vice versa. Second, since 1997 one asset or the other (stock, real estate) has been in a constant Bubble state meanwhile the Fed targets (inflation, GDP) behaved conservatively. You can see the data within the workbook Bubble model.xls Dot.com Stock market bubble Housing bubble Double digit inflation during Volcker years
Monetary Policy = Scalextric You may remember this game where you drove a single car with electric controls and raced against your friends. Now, the four cars represent the different macro variables. They are on totally different positions on the economic curve and need to be driven at different speed. Yet, the Central Banker has only a single set of controls to drive all four cars (variables)!
Partial policy solution (utopian?) ideas <ul><li>Home price changes should be aligned with inflation. Right now they are not. They actually depress inflation (through the rent-equivalent mechanism). </li></ul><ul><li>The Federal reserve to manage mortgage underwriting standards (downpayment level and debt/income ratio). This would give the Fed a separate accelerator/decelerator dedicated to managing home price growth. </li></ul><ul><li>Fed to aggressively manage stock margin requirement (another accelerator/decelerator just for stocks). </li></ul><ul><li>Capital gains rate to start much higher and be aggressively tiered downwards over a long period of time (at least 5 years) to reduce speculation. </li></ul>
There is no finish line <ul><li>Just as in a video game where the game’s challenges increase as the player skill level improves, a Central Banker could always face more complex and contradictory policy challenges. Here are a few candidates: </li></ul><ul><li>Managing the $ FX rate level; </li></ul><ul><li>Addressing the Current Account Deficit; </li></ul><ul><li>Preempting other asset bubbles such as commercial real estate among others. </li></ul><ul><li>This is just like adding another 3 cars to the Scalextric game while still being stuck with a single accelerator/decelerator to control now all 7 cars. And, some of the cars may be going in opposite direction. </li></ul><ul><li>Additionally, with financial globalization the Fed has less and less control on related international money flows and interest rate levels all along the yield curve except at the very short-term end. So, the Central Banker’s controls’ battery is getting pretty run down. And, there are no readily available battery replacements. </li></ul>
Job Ad for Bernanke’s successor The less the better. Whenever you open your mouth, the stock market could crash. And, it would be all your fault. Communication style Once the Fed is done with you, we guarantee career burn out. Career prospect Whatever went wrong will be your fault. Whatever did not was due to randomness. You’ll read it in Wikipedia. Legacy Solve problems before they emerge, otherwise you will be blamed for them. Responsibilities Your boss is the bond market. Expect communication challenges. No hand holding here. Hierarchy We grossly underpay to keep the hedge fund crowd away. Pay We offer no vacation. See “Lifestyle” above. Benefits Financial crises don’t sleep. You shouldn't either. Lifestyle Expect ambiguity. Whatever worked is history. Impact At any one time half the financial community will be really upset at you. They’ll give you plenty of feedback. Feedback
Appendix: Sources <ul><li>GDP growth is from the BEA. Quarterly seasonally adjusted data. Annualized figures. </li></ul><ul><li>Inflation is from the BLS. Represents annual change in CPI from four quarters ago. </li></ul><ul><li>Median Home price is from NAR. Median family income (denominator) is from U.S. Census through Moody’s Economy.com </li></ul><ul><li>Domestic equity market cap is from Flow of Funds data L213. Nominal GDP (denominator) is from BEA. </li></ul>