Sunday, September 21, 2008

End of the bubble era?

David Leonhardt feels that the extraordinary events of the last week could be the climax of the decade and a half long serial bubbles, first in tech stocks and then in real estate, both fuelling another one in consumption.

He writes, "A guiding principle of economic policy in recent years has been that nobody is smart enough to diagnose a bubble until it has already deflated. This was one of Alan Greenspan’s mantras during his tenure as the chairman of the Fed... no matter how high stock prices rose relative to profits, or no matter how high house prices rose relative to rents, regulators deferred to the collective wisdom of the market... Pricking a bubble before it grew too large could stifle innovation and hurt other parts of the economy. Cleaning up the aftermath of a bubble is easier and less expensive. We’re living through that cleanup now."

The dot com crash at the turn of the millennium did not wring out the excesses of the nineties stockmarket bubble. The "Greenspan put" and a period of historically low interest rates, blew up another bubble in real estate and mortgage securities, which in turn limited the deflation of the tech stock bubble. All these created a "wealth effect" that triggered a "consumption bubble" which was in turn fuelled by a "savings glut" in emerging Asia and the voracious export appetite of China. These bubbles fed into each other, thereby linking up the real economy and the financial markets.

As the excesses built up, aided by the deregulation wave (repeal of the Glass-Steagall Act in 1999), the financial sector continued to grow at breakneck pace. As late as 2004, financial services firms earned 28.3% of corporate America’s total profits, double the share in the seventies and eighties. Of every dollar paid to the American work force in 2008, almost 10 cents went to people working at investment banks and other finance companies, up from about 6 cents or 7 cents throughout the seventies and eighties. An indicator that things may have retained some semblance of normalcy is the fact that the Price to earnings ratio has dropped from a historic high of 36 in 2000 to the post-war average of 17.

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