Bubblenomics

Some people will read this and say, “No inflation, no problem.” But that completely misses the point of asset price volatility and distortions of resource allocations. People complain about inequality, but then ignore these policies that aggravate inequality while making unequal outcomes rather arbitrary. In the meantime we live in a far more volatile and precarious world.

The Federal Reserve’s everything bubble

Desmond Lachman, May 19, 2020

Good economic policymaking resembles good medical practice. In much the same way as a skilled doctor’s effective prescription for a disease rests on an accurate diagnosis of the illness, so too a wise economic policymaker’s effective crisis policy response depends on a comprehensive understanding of the crisis’s underlying causes.

One has to regret Federal Reserve Chairman Jerome Powell’s seemingly partial diagnosis of our present daunting economic challenge, especially considering his key role in defusing the crisis. In Powell’s view, our economic predicament has nothing to do with the possibility that years of ultra-easy U.S. monetary policy might have contributed to the creation of worldwide asset and credit market bubbles. Rather, he seems to believe that our economic challenge is solely the result of the supply side shock delivered to the economy by the coronavirus pandemic. 

Following the bursting of the U.S. housing and credit market bubble in 2008, it took the U.S. economy some six years to regain its pre-crisis employment level. Dismissing any notion that the coronavirus pandemic might now be bursting asset and credit market bubbles of the Fed’s creation, Powell believes that this time around we could have a quicker economic recovery than we did following the 2008-2009 Great Recession. 

Indeed, Powell believes that the U.S. economy could fully recover by the end of 2021, notwithstanding the very much deeper economic recession that we are now experiencing than in 2008-2009. 

Despite Mr. Powell’s assertions to the contrary, over the past decade the Fed, along with the world’s other major central banks, created a global asset and credit market bubble. They did so by buying a staggering cumulative $10 trillion in low-risk government and private sector bonds with the aim of forcing investors to take on more risk and to stretch for yield. The net result of that policy was the creation of a global equity and housing market boom as well as the major distortion of world credit markets.

One indication of the world equity price bubble was the very high valuation to which the U.S. equity market reached before its large coronavirus-induced correction earlier this year. Measured by the cyclically adjusted price-earnings ratio, before the pandemic’s onset U.S. equity valuations reached lofty levels experienced only three times in the past hundred years. Meanwhile, numerous housing markets around the world, including those in several large U.S. cities, had price-to-income ratios that exceeded those reached at the 2006 peak of the earlier housing market bubble.

More troubling yet, the world’s major central banks have distorted global credit markets in a major way, as investors were encouraged to take on excessive risk. One indication of such credit market excess was the more than doubling in the risky U.S. leveraged-loan market to its present level of around $1.3 trillion. Other indications were the approximate doubling over the past decade of lending to the emerging market economies and the very low interest rates at which highly indebted countries like Italy were able to finance themselves. 

A key point to which Powell is choosing to turn a blind eye is the great likelihood that the very depth of the current economic recession, which is almost certain to be the worst experienced in the past 90 years, will burst asset price bubbles around the globe and make it all the more difficult for debtors to service their loans. This will be particularly the case for the travel, hospitality and entertainment sectors of the world economy that are bound to be particularly hard hit, at least until a COVID-19 vaccine is made widely available. If a wave of debt defaults and bankruptcies were to occur, we could see real stress in the world financial system. [The only option the Fed has at this point is to ramp up ZIRP and QE4ever as well as underwrite US Treasury borrowing.]

Another key point that Powell seems to overlook is the likelihood that the global economic recession could trigger both another round of the European sovereign debt crisis and yet one more major emerging market economic crisis. In this respect, it is hardly encouraging that the European economic recession shows every sign of being deeper than that in the United States and that Europe is still struggling to fashion a united fiscal response to the recession. Nor is it encouraging that capital is being withdrawn from the emerging market economies at a record pace and that a number of emerging market currencies already appear to be in free fall.     

To his credit, Powell responded both boldly and promptly to the initial phases of the current economic crisis. Hopefully, he stands ready to do more of the same at the first signs of real stress in the global financial system. If not, we can be sure that our full economic recovery will be delayed until well after the end of 2021. 

[Not sure how writing more trillion$ blank checks really is a solution.]

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.


The problem we see here is that the world’s economies, made up of the world’s citizens, have been dangerously pushed out on the risk curve. Meltdowns of inflated asset values are sure to occur and each one means we are less able to respond to excess risk and loss. The USA is in an envious position because its control of the world currency means all those dollars come back to the US economy to buy real assets, so those who own those assets (Americans) are far more fortunate than those who want to buy them. But this only means more economic and political volatility across the globe.

Viral (or Vile) Media

I start my morning reviewing the headlines of the major news media on RealClearPolitics to see if there is anything worth reading. Of course, RCP now juxtaposes the ying with the yang on every issue in order to drive engagement and traffic. Today I came across these two articles and was struck on how they captured the manufactured controversy over ending or maintaining virus lockdowns. Give them a read and see if you can perceive the difference.

How to reopen the economy with a reality-based approach

https://www.washingtonexaminer.com/opinion/how-to-reopen-the-economy-with-a-reality-based-approach

The first, published in the esteemed (sic) NYT, is written by a professor of pediatrics. I read it through, hoping to gain some insights. Sadly, incredibly obtuse, he makes assertions about epidemiology and public opinion and dismisses experts from the fields of psychiatry, politics, economics, and social behavior with a fairly baseless argument that only the medical experts know. We must follow their advice without question (okay, let’s ignore the fact that every medical projection has been off by a country mile). Then he adds that public opinion agrees. Okay, a public survey poll is an obvious contradiction of expertise: if 60% of the lemmings say we need to go over the cliff, the other 40% better follow?

He tried to obscure this error with a survey of economists. As a trained economist I happen to know the profession is one of the most risk-averse in academia (note the quoted economist who doesn’t want to be a restaurant guinea pig). Why? Because we are painfully aware of how much we don’t know (and make sure to maintain plausible deniability for those bad forecasts – Paul Krugman take note). There is no actionable intelligence in this opinion piece, as that’s what it is, unqualified opinion.

The second piece is published by the less esteemed (?) Washington Examiner (hmm, presenting a perfect opportunity to shoot the messenger and kill the message?), written by an MD and JD trained in economics. This writer offers a nuanced strategy with actionable intelligence for opening up parts of society while maintaining certain social behavior protocols to manage the risks. Okay, not bad.

My advice: trash the NYT piece and don’t take the WE piece as gospel, as that is not how it is intended, but give it careful consideration. There’s no equivalence here. Our media seems committed to misguiding at least half the country’s citizens. Ugh!

Social Behavior and the Coronavirus Pandemic

If you’re like me and follow the mainstream as well as social media, you’ve likely been inundated with information about the coronavirus pandemic, with many different data interpretations and conflicting claims based on these interpretations. The simple graphic below, called “flattening the curve,” seems to be the dominant visual for explaining the current public healthcare issues and provides a good starting point.

Flattening the curve.

The graph was created by disease specialists at the CDC and has been spread widely by medical professionals, government officials, and non-government agencies. It visually represents the logic behind the political response to the crisis and the strategy to slow the spread of the virus. This is critical to managing the capacity limitations of healthcare resources like hospitals, drug therapies, and healthcare personnel. However, it is a theoretical model based on exponential pandemic dynamics; it is not a graph of actual empirical data. It is meant to educate, not report.

Unfortunately, the graph has been adopted by public media as a projection of “likely” real-time scenarios under various assumptions, focusing completely on the rose-colored part of the graph. According to this worst-case scenario, without strict adherence to isolation protocols the coronavirus is projected to spread exponentially through the population, placing an impossible burden on healthcare resources. The problem is that the empirical data so far does not seem to be supporting this worst-case scenario.

Let’s not get derailed here: the virus outbreak is a serious public health threat and a deadly threat to the elderly and immune-compromised. Our policies should foremost target the security of these groups. In this respect, the model is valuable and instructive, but not so much for actual health outcomes to the majority of the population. From the macro point of view, we have little idea how many of those people infected will require medical intervention and how extensive that intervention might be. In other words, infection rates may not impact health care capacity as depicted here. We also have little feel for how high or low that spike might be, or the magnitude of the y-axis – is it thousands, millions, or billions? 20%, 50% or 90%? Many media interpretations of existing data choose a scale that looks like we’re shooting up to the top of that rosy peak when we are really barely past the initial stage way, way down near the floor of the x-axis (see next graph). The projections repeatedly fail to project for interventions and behavior changes.

Where are we?

Also, as we discover more and more people have contracted the virus yet show no serious symptoms, we are missing any projection of herd immunity. Immunity gradually reduces the ability of the virus to find new hosts within the existing population so it gradually dies out.

What is valuable about the meme is the implication for how the public should adapt social behavior now to reduce the transmission rate of the contagion. Physical or social distancing is at this time imperative. Essentially this is less about biology and more about social behavior informed by biology. It strikes me that most of our media information is overly focused on very uncertain medical data given credibility by concerned medical experts. The problem is that the experts are shrouded in uncertainty and thus must err on the side of extreme caution. In hindsight most of this speculation will likely turn out to be fictional. But the effect will be real, and this takes us back to social behavior.

Some reports opine that this coronavirus is just a bad flu. If one is looking at medical data, I would tend to agree. But looking at social behavior, I would obviously disagree. What is driving social behavior, which will be measured in political policies and economic results, relates to the nature of this pandemic, not the pathogen itself. The coronavirus strikes at the heart of our instinctual behavior in the face of existential threats.

The real problem we face is that 1) the threat is invisible, 2) seems to be highly transmissible and somewhat random, 3) offers no preventive therapy (vaccine) or 4) sure treatment options or cures. Thus, 5) we feel little sense of control over what might be a serious existential threat. What this combination of characteristics does is incite a strong psychological reaction to uncertainty, risk, and potential loss, leading to exaggerated reactions to very low probabilities.

We know from behavioral science that the survival instinct causes behavior to respond to these contextual parameters. Humans, like all sentient beings, are risk and loss averse. Loss pertains to the nature of the threat, such as will I lose my job, or my savings and pension, or the ultimate existential threat: will I get sick and die? Risk is a probability function of the uncertainty of that loss. As the threat level rises (reported death counts and mortality rates) people become more fearful. Then, as uncertainty blankets us like a fog, the anxiety level rises. This survival response is perfectly rational for any organism trying to stay alive.

The important thing to note is that when the probability of loss increases and the consequence becomes more serious, people tend to become risk-seeking. In other words, faced with a likely existential threat, people take more behavioral risks than would be rational in the absence of that threat. We see this in those apocalyptic movies, when widespread hysteria and panic leads to chaos and deadly conflict, where more people die from the chaos than from the threat.

Individual behavior is compounded by irrational social behavior. An example is the panic buying of paper products, where some people, pressed to explain their behavior, have only offered the justification that everybody else was hoarding paper, so they were too. This suggests that what may not be categorically much different than a bad flu medically has the potential to turn into a global social and economic crisis.

So why is this reaction to coronavirus different than the Asian bird flu, Ebola, SARS, MERS or H1N1? The coronavirus seems to have a much higher and faster transmission rate than these previous pathogens and thus it has spread world-wide much faster. This is likely because it is highly asymptomatic while it is contagious and spreading. It also may be far more benign. But we don’t know why it is asymptomatic in some people and severely life-threatening for others. This uncertainty and randomness heighten our fear of the threat.  

There is something else going on with the present pandemic that is aggravating the crisis. Because the virus has easily spread rather quickly, our global information media has gone into overdrive, especially social media. We know that social media is mostly driven by emotional reactions to uncertain facts, what we now call fake news. The sad reality is that the traditional print and broadcast media have also had to succumb to sensationalism and emotions in order to stay in business. Remember the editor’s dictum: If it bleeds, it leads. This presents the danger of reporting one random healthy young person who dies of COVID-19 complications instead of the thousands of others who contract the virus and seem unaffected. Our media, willingly or unwillingly, by focusing on infection and death counts taken out of context may be contributing to the social psychological effects driving this pandemic crisis. Worst-case scenarios painted by the medical experts and spread by the media are doing the same.

I suspect officials may sincerely believe projecting the worst-case scenario is necessary to “scare people straight” to get them to change behavior. But social behavior indicates that fear can become more viral than the virus, increasing the threats to social stability, safety, and security.

If one doubts this, imagine what would happen if a vaccine or cure were discovered tomorrow. Most of the world would return to normal the next day, not because the pathogen was eradicated any more than the seasonal flu, but because our fear would disappear.