Mishkin’s idea of bubbles and lessons from economic history

I am pretty late on this. There is already a fair bit of criticism on the new Mishkin bubble article (see Eurointelligence, Caroline Baum, TT Ram Mohan etc etc).

He says there are 2 kinds of bubbles. One credit boom bubble and second irrational exuberance bubble. First causes damages and needs to be looked at and second one just ignore it.

The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

A bubble is a bubble. Just because it is an irrational exuberance driven bubble doesnt mean it is not dangerous. The costs of the bubbles in 1987 and dotcom may have been less but it was just plain good luck and they burst a little early. Again the current bubble was also driven by the mad exuberance towards search for yield found in housing assets. And then till 2007 it was all seen as manageable and then it all burst. I don’t think we can classify bubbles like this.

However, what is even more bugging is when he says the current rise in asset prices isn’t a bubble:

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture. The Fed decision to retain the language that the funds rate will be kept exceptionally low for an extended period makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations. At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

But weren’t the same conditions seen in 2001 when rates were kept low again for an extended period? And then a disaster followed after 6 years.

The point is one should be weary of a quick rise in prices of any kind of asset market. There is nothing which changes so quickly justifying a big jump in asset prices. One can always cross question Mishkin’s argument that why are asset markets rising so quickly if the economic situation is so bad? I mean one can understand a gradual rise but the way they have been zipping is certainly something to worry about. It looks like again a big bubble especially when we are told there is too much slack in the system etc. With zero interest rates and so much liquidity the chase for higher yield is all the more.

I also keep wondering this. We always talk about economic history and its lessons to fight and mitigate the impact of crisis. So when a crisis starts, we refer to what Japanese did (and didn’t), What the Nordic countries did, what the South east Asian did etc. In this crisis, we have taken large lessons from Great Depression as the crisis became as deep as the 1930s event.

But why do we forget lessons from economic history when the bubble conditions start? Why do we start thinking of the growth situation as different and fancy? Isn’t that part of the economic history lesson as well? It is the more important lesson which we just want to forget.

The policymakers need to talk tough and r’ber eco history not just in times of crisis but in times prior to the crisis as well. There is no point justifying each growth episode as something great and needed. It just doesn’t help. The end result is disastrous for all.

Addendum:

I  have said this before and am repeating it. I have been a big fan and an avid reader of Mishkin’s work. His writing style is top class and explains ideas really clearly and simply. This Blog started in 2007 and initially lots of posts were dedicated to his work and speeches as he was Fed Governor then.

It is just amazing how this crisis has forced rethinking on much of Mishkin work. I had earlier pointed to his Iceland report before the crisis, which said Iceland was ok. His paper presented in 2007 Kansas City Fed conference on housing bubbles has been off the mark as it underestimated the crisis. Then his this piece on bubbles has been much criticised. The good thing is he acknowledges bubbles are dangerous and mon policy needs to look at them. This was not there before the crisis.

I also came across this paper by Mishkin which says Too Big Too Fail is not as much a problem.

This review essay examines whether too-big-to-fail is as serious a problem as Gary Stern and Ron Feldman contend. This essay argues that Stern and Feldman overstate the importance of the too-big-to-fail problem and do not give enough credit to the FDICIA legislation of 1991 for improving bank regulation and supervision. However, this criticism of the Stern and Feldman book does not detract from many of its messages. Even if the too-big-to-fail problem is not as serious as they contend, the policies they outline can make it less likely that a banking crisis will occur even if driven by other factors. 

How times change? This does not mean I wouldn’t read his work. Just that need to ask more questions and not take it as seriously as I used to.