Selgin is right, but it's an endless battle
In a recent tweet, George Selgin pushes back against the view that the Fed creates asset price bubbles that persist for more than a decade. But then why do these theories keep finding support?
The basic problem in economics, especially in macroeconomics, is that people tend to believe what seems plausible, not the view supported by scientific theory and evidence. The field is so complex that many interpretations are possible. This is why macroeconomics is cyclical, much like many of the arts, or like the hemline of women’s dresses. Theories go in and out of fashion for one simple reason—their plausibility varies with the state of current events.
There are three true facts that give the hypothesis of Fed created asset price bubbles a superficial plausibility:
1. Over the very short run, the Fed controls short-term interest rates via monetary policy.
2. When the Fed cuts its interest rate target, asset prices often rise immediately on the news.
3. Market interest rates have been trending lower for more than 40 years, and asset prices have risen sharply.
An average person looking at those three true facts might be inclined to reason as follows:
“The Fed has been reducing interest rates on and off for 40 years. We know that asset prices rise when the Fed reduces interest rates. Asset prices have rising sharply in recent years, far faster than the overall rate of inflation. Hence asset price bubbles are being created by expansionary Fed policy.”
Here’s why this view is a cognitive illusion:
1. Real interest rates have been trending lower for 40 years for reasons essentially unrelated to monetary policy. The Fed has cut its target rate in response to falling equilibrium interest rates. It’s a follower, not a leader. If that were not the case, inflation would have been accelerating over the past 40 years. There is absolutely no mechanism by which money can “go into” asset markets but not goods and services markets. Monetary policy is either inflationary, or it isn’t.
[BTW, money doesn’t actually “go into” markets, it goes through them. For instance, did lots of money “go into” the stock market on October 19, 1987, when stocks crashed by 22% on record volume?]
2. When the Fed cuts its target short-term interest rate by more than expected, long-term real interest rates sometimes rise. But even in those cases, stock prices often rise sharply (for instance, on January 3, 2001.) The mostly likely explanation is that both stock prices and long-term real interest rates rose on expectations that monetary easing would lead to higher economic growth.
These facts lead to a situation where people are especially likely to see imaginary “bubbles” after long periods of a depressed economy—a cognitive illusion. During these periods, news of monetary stimulus may boost asset prices for reasons essentially unrelated to lower interest rates—expectations of faster growth. Interest rates become a mere epiphenomenon. At the same time, “secular stagnation” leads to lower equilibrium real interest rates, which means future expected rents and dividends are discounted at a lower rate. That makes the equilibrium level of house and stock prices unusually high relative to rents and dividends, looking to the average person like a “bubble”.
Many years ago, I predicted that people in the 21st century would be obsessed with “bubbles”, a topic hardly even mentioned by economists during the first 30 years of my life (1955-85). It’s an endless battle, because most people will always go with the view that is intuitively plausible.
HT: Patrick Horan