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Wednesday, April 30, 2003

B is for Bubble

Via Angry Bear I discovered the very partisan Democratic econoblogger Matt Stoller, who worries about a bond-market bubble in the US:

Markets that are too frothy exhibit certain characteristics, one of which is the entrant of amateur investors who think they can't lose because that's what they've been told. Remember a few years ago when stocks were a can't miss investment, and even if they went down, over the long haul they would go up? And then many of them went to 0.

Well, when the 'dumb' money is late to the party, the party is over.

So this quote should give you pause:

“I would never have bought a bond” before the stock market’s swoon, said Soury, 50, who runs a public relations firm in New York. “Now they look like a gold mine.”

When the national savings rate is low, the power of the Federal Reserve to manipulate the economy is dramatically reduced, as essentially foreigners decide whether to set rates high or low based on whether they want to invest. Foreigners make decisions with different priorities than a central bank, and react badly to instability (think third-world financial meltdowns). Low rates set by the Fed have had a much weaker effect than they did in 1992, reflecting precisely our weakened financial position.


Lots of people are worrying about the US current account situation, concernd that it is unsustainable in the medium-long run. Stoller, though, it talking about two differnent things. It is true that bonds are providing higher returns than equity markets right now, but how much that influences ordinary inverstors is questionable. The very report that Stoller cites is based mainly upon anecdotal evidence, not on an empirical finding that significant numbers of Americans are shifting their savings into bonds (though that may very well be the case).

If what Stoller says is correct, there is even more cause for worry. Housing bubbles, though, as the IMF notes, are a greater concern in the short run. If the US bond marker busts, though, is will correctly be because of a loss of confidence among foreign bondholders. Despite the IMF's emphasis on "confidence building" duing the 1997-98 Asian crisis, there still no good way of explaining their behavior, especially in a market as big as the United States.