How does the world economy adjust when the propensity to save exceeds the propensity to invest? It has to adjust somehow, since total saving has to equal total investment. Broadly speaking, there are two mechanisms by which it can adjust. The first is that incomes can fall, held down by weak demand from firms choosing not to invest or households choosing not to spend. (This leaves less income available for saving and thus forces total saving to fall.) The second is that asset prices can rise, bid up by savers looking for a place to put their savings. (This increases the incentive to invest and decreases the incentive to save.) Over the past decade, the world has consistently faced an environment in which the propensity to save exceeded the propensity to invest, and various nations, at various times, have adjusted by one mechanism or the other. It should be obvious – and used to be obvious, at least to mainstream economists – that the latter mechanism is preferable.
During the recent US housing boom, I was of the school that believed rising house prices were an example of that preferred mechanism taking effect. At the time, I had plenty of company. Today – now that we have transitioned to the less preferred mechanism for equating saving and investment – my cohorts all appear to have deserted. Apparently it is now generally accepted that the rise in house prices was an aberrant bubble, justified only in the minds of irrational buyers who ignored the fundamentals and expected house prices to keep rising simply because they were already rising.
But what were the fundamentals? Certainly, if one had foreseen today’s circumstances, it would have been clear that housing was not a good investment. If one had been able to say, “In a few years, the unemployment rate will rise to 10%, the inflation rate will fall to nearly zero, and policymakers will be too timid to undertake the policies necessary to reverse those trends,” then it would have been clear that 2005 was not a good time to buy a house. But that’s not what most housing bears were saying at the time. And in any case, while investors must of course do their best to anticipate actual policies, it is hardly appropriate for economists to consider the anticipation of future policy timidity as part of the intrinsic fundamentals. It is hardly reasonable to declare an episode a bubble just because investors failed to anticipate the timidity of policymakers.
Less timid policies – which are indeed advocated today by a great many of the erstwhile housing bears – would have two salient features: a commitment (in some form) to higher inflation rates over the medium run and (in pursuit thereof) an aggressive attempt to reduce interest rates across the yield curve. Under those circumstances, houses – a classic inflation hedge that could be purchased with ultra-cheap financing – would seem like a very good thing to own. If such policies were undertaken, and housing prices were to rise once again to their former level, would the bears once again declare the housing market to be a bubble? Perhaps housing prices wouldn’t rise quite so much, but some asset prices would have to rise quite a lot to bring about full employment and moderate inflation. It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude.
It is of course conventional (but wrong, in my opinion) to regard the current malaise as the result of the housing bubble’s collapse, so perhaps it will be argued that such asset-boom-inducing policies are needed now only because that housing boom already took place. That argument makes little sense to me. Back in 2003, as the housing boom was already taking form, the US economy was weak enough to raise deflation concerns at the Fed. The housing boom (along with its collateral effects on things like consumer spending) was precisely what drove the subsequent recovery and alleviated those concerns. And even with the tremendous stimulus of the housing boom, that recovery barely reached full employment and stopped far short of a macroeconomic boom. Surely, without the housing boom, the US economy would have remained weak, and we would have ended up in much the same situation we are in today.
I would challenge those who believe there was a housing bubble (which is, today, nearly everyone) to come up with a coherent and believable scenario in which those supposed bubble prices would have proven unjustified without either (1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us or (2) being replaced by a “bubble” in something else. I submit that the term “bubble” is inappropriate. What we had were the makings of an equilibrium that involved very high asset prices (and low subsequent asset returns), the only equilibrium that would have allowed saving and investment to equate at a level high enough to avoid foregoing potential aggregate income. Perhaps, in 2006, housing prices were a little bit overvalued relative to that equilibrium, while some other asset prices were a little bit undervalued; but in general, very high asset prices were a critical feature.
In any case we are far away from that equilibrium today. Asset prices are far too low to bring us anywhere near full employment. Relative to that “classical” equilibrium, asset prices are far below where they should be, and prospective asset returns are far above where they should be. That’s not to say that prospective returns are necessarily high in historical terms: in the classical equilibrium, when a lot of people (and nations and institutions) are trying to save, they bid down the returns that can be earned on those savings. And that’s just the thing: we need to get to the point where houses (and stocks and bonds and everything else that people hold for the future) are very expensive, not because prices are expected to keep rising forever but because people realize that low returns are the best deal they’re going to get. Along the way to that equilibrium, though, asset prices will have to rise. Unfortunately, current policies do not appear to be moving us in that direction – at least not very quickly.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
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