Do barriers create "bubbles?"
Ryan Avent discusses a recent speech by Larry Summers:
The basic set-up of his narrative remained unchanged from last year. Imagine a world, he said, in which resources are increasingly concentrated in the hands of those with high propensities to save and low propensities to invest: reserve accumulating foreign governments, for example, and the very rich. In that world, the real rate of interest that clears the market–that balances savings and investment and therefore ensures that no willing workers are left unemployed–could fall to and remain at very low levels.
It could fall to such a low level that the central bank would need to keep its policy rate near zero to clear the market; with interest rates near zero, asset prices would soar, such that a full-employment equilibrium inevitably meant a dangerous rise in financial instability. Alternatively, the market-clearing interest rate could fall below zero, leaving the central bank unable to move its policy rate low enough to generate adequate demand and trapping the economy in a prolonged slump.
Ryan has lots of astute things to say about that final sentence, but I’d like to focus elsewhere. I’ve also argued that low rates will create more “bubbles” in the 21st century. Scare quotes reflect the fact that I don’t believe in bubbles, when I say “bubbles” I am referring to unusually high asset prices, by historical standards.
Bill Woolsey has a good counterargument:
One of Summers’ arguments for fiscal policy is that the low interest rates generated by monetary policy results in excessively high asset prices.
While it is true that given the expected return on an asset, a lower interest rate raises the asset’s present value, the problem is supposed to be “secular stagnation.” There is an excessively high supply of saving and excessively low demand for investment.
But the low demand for investment is being generated by low expected returns on real investment. Given the interest rate, that results in a lower present value of an asset. And to the degree that excessive saving is driving down the marginal return on investment, the result is the same.
And so, secular stagnation should lower asset prices at a given interest rate. The lower interest rate, then, simply dampens the decrease in asset prices.
Can we agree with both of them? Let’s try. I claim that during the first period of extended low interest rates (1930-51), the US was in a Woolsey world. There weren’t many asset price movements that looked like bubbles. That’s because if the price of assets like apartment buildings in Manhattan or car factories in Michigan started rising, people and companies would simply build more of those assets. It was easy to do. So the low marginal returns on investment also reflected low average returns on assets. Asset values remained moderate.
Today when the price of apartment buildings in New York or the price of residential housing developments in San Jose soar in value, people don’t build very many more of them, as it’s hard to get permission. And when the value of Facebook and Twitter rise, people don’t build more Facebooks and Twitters, because copyright laws forbid this. Of course they could build more Facebook-like firms, but many of these companies have important network effects, or sell output at a zero price and rely on ads (winner-take-all). Or they require a genius with a new idea. That makes it harder to break into this industry than it was to start a new refrigerator factory in Ohio in 1947.
My prediction is that in a low interest rate America, asset “bubbles” are most likely to form in sectors with barriers, such as coastal real estate and NASDAQ stocks that are “intellectual property” plays. And bubbles are less likely in Chinese stocks, as China relies more heavily on basic manufacturing, which can be replicated.
So a combination of low real interest rates caused by very weak returns on capital at the margin, and high average returns on infra-marginal capital in sectors protected by zoning and IP laws, will create “bubbles.”
And that’s as it should be given those laws exist. Of course both zoning and IP laws should be weakened, even if we didn’t care about inequality. And if we do care about inequality then the argument for weakening zoning and IP laws becomes almost overwhelming. Ditto for occupational licensing laws.
PS. I realize that my theory doesn’t always work; there were those high Chinese stock prices in 2007, and the high Phoenix house prices in 2006.