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The bubble century

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[Don’t forget to check out the new Mercatus paper on housing and monetary policy during the Great Recession. (Written by Kevin Erdmann and me.) Also, I rarely change my mind on monetary policy, but today I did (at Econlog).] Over the past decade, I’ve frequently argued that this will be the century of “bubbles”. I use scare quotes because bubbles don’t actually exist—i.e. they are not a useful concept. Rather this will be a century full of asset price movements wrongly seen as bubbles.Here’s yesterday’s FT: A collapse in real yields — the return that bond investors can expect once inflation is taken into account — is rippling through global financial markets and driving record rallies in assets from gold to technology stocks, investors say. Let’s go back to July

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[Don’t forget to check out the new Mercatus paper on housing and monetary policy during the Great Recession. (Written by Kevin Erdmann and me.) Also, I rarely change my mind on monetary policy, but today I did (at Econlog)

Over the past decade, I’ve frequently argued that this will be the century of “bubbles”. I use scare quotes because bubbles don’t actually exist—i.e. they are not a useful concept. Rather this will be a century full of asset price movements wrongly seen as bubbles.

Here’s yesterday’s FT:

A collapse in real yields — the return that bond investors can expect once inflation is taken into account — is rippling through global financial markets and driving record rallies in assets from gold to technology stocks, investors say.

Let’s go back to July 2011, and see why I expected a “bubble” century:

But (seriously) are stocks now overvalued? Because I’m an efficient markets-type, the only answer I can give is no. So why does Robert Shiller say yes? Apparently because the P/E ratio is relatively high by historical standards. And he showed that for much of American history investors did better buying stocks when P/Es were low than when P/E ratios were high. Of course hindsight is 20-20.

I’d rather not get into the minutia of all the various ways of calculating P/E ratios. And I have no idea where stocks are going from here. Instead I’d like to focus on three arguments for relatively high P/E ratios in the 21st century American economy (however you’d like to measure them):

1. Stocks have done very well since the 1920s, which suggests that 20th century P/E ratios were usually too low.

2. American companies are making lots of money in the worst recession since the Great Depression. This is partly because US multinationals are making huge profits in the developing world. And this suggests that traditional market indicators based on the ratio of US corporate profits to US GDP may be outdated. US GDP is no longer the relevant denominator. So “E” may be relatively high for the foreseeable future.

3. My most important argument is that low real interest rates might be the “new normal.” The most striking characteristic of the US economy over the past decade is the unusually low level of both nominal and real interest rates. And it’s not just because of the current “unpleasantness;” rates also fell to very low levels in the early 2000s. Why have people missed this story? I believe it’s because they’ve assumed the low rates are some sort of Fed policy, not a free market outcome. But if the low rates since 2001 were an easy money policy, then why didn’t we see high rates of inflation and NGDP growth? So money hasn’t been easy, which we should have [been] obvious all along, given that INTEREST RATES ARE NOT THE PRICE OF MONEY, THEY ARE THE PRICE OF CREDIT. And these low real interest rates should support a higher P/E ratio.

I am a market monetarist because it provides the framework for making sense of what’s happening in the macroeconomy and the financial markets. If you thought that interest rates were being “artificially” depressed by the Fed back in 2011, then you’d naturally expect them to “bounce back to normal” at some point. Those people may be in for a long wait.

PS. Recall all those bubble articles written in 2002, when NASDAQ had fallen below 1200? Back when people laughed at all the fools who (in 2000) had believed that it made sense to invest in companies with no profits, like Amazon? Who’s laughing now?


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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