May 12, 2008


My posting last Friday, Foreign Exchange Insights, opens with a discussion of recent oil price developments and observes that “it’s much easier to spot an asset bubble than to predict when it will deflate.” By coincidence, the esteemed Princeton economics professor and New York Times columnist, Paul Krugman, has a self-explanatory Op-Ed piece today, The Oil Nonbubble. Krugman defines “bubble” more narrowly than I do. We both agree on the long-term unsustainablility of a bubble, but he includes the stipulation that speculation in some form has caused the bubble. Without an element of speculation, there is no bubble. In my definition, no such limitation is required. If oil prices are higher than fundamental forces justify, I submit that the bubble metaphor is apprpriate — it will implode sometime in the future — whether or not anybody colluded intentionally or not to create the unsustainable situation. As noted in my May 9th posting, oil prices had risen more than 100% since May 9, 2007 and by 8.1% (over 5600 percent if continued for a year) in the latest week. Amid declining global demand, even in emerging markets, one can say that higher oil prices than a year ago make sense but that the extremely steep and accelerating advance does not. It if looks and acts like a bubble, it’s a bubble.Here’s another example of a market bubble. Over the last 61 years, the Dow Jones Industrial Average rose 7.4% per annum, which set against real U.S. economic growth of 3.4% per annum and a reasonably steady ratio of corporate profits to GDP seems reasonable. But stock prices did not make this journey in a steady way. For 14-1/2 years to December 1961, the DJIA advanced 14.6% per annum, and for 17-1/2 years to January 2000, it increased by 16.9% per annum. Those periods of excessive appreciation, an expanding bubble if you will, alternated with periods of consolidations, i.e., bubble deflation.
Bubbles happen in foreign exchange, too. From the start of 1980 to February 1985, a U.S. macroeconomic mix of very loose fiscal policy characterized by a huge federal deficit and very tight monetary policy with very high inflation-adjusted and nominal interest rates doubled the dollar’s external value. Economics textbooks speak of price equilibrium as a point, a single price that matches quantity supplied and demanded at a price that once secured only moves when underlying determinants of supply or demand or both change. In fact, markets frequently behave in a way that defines equilibrium as a price direction. Fundamentals may be perceived to favor the dollar over a long time, as such did in 1980-84, and throughout that whole period the dollar’s path of least resistance was up. By late February 1985, the dollar at 3.48 Deutschemarks and 263 yen had climbed to levels that were damaging enough aspects of the global economy to produce a major trend reversal. Economists long before that reversal were anticipating that an eventual downturn of the dollar was just a matter of time.

Bubbles sometimes characterize non-price concepts. The present U.S. current account deficit is a bubble. As a percent of GDP, the shortfall remains far greater than previous historical extremes. Even though air has been let out of the deficit already, the adjustment process is almost certainly far from complete.






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