It is not that difficult to see a bubble forming and to predict that it will burst. The best indicator for a bubble is when the prices no longer have a relation to the underlying asset. This is the case when house prices are increasing much more than people’s incomes, or when the prices of shares increase much more than what the companies are earning. That is where we are now in many developed countries.
Let us start with the housing market. A simple indicator for what is going on is to look at the ratio between house prices and what people earn (the median income). The figure below which we have borrowed from https://www.longtermtrends.net, shows that in the US on average the cost of a house is more than 7 times of what people earn in a year. This is more than what it was just before we had the latest financial crisis in 2008.
This pattern can be seen in many other countries too. According to data from OECD, the increase in house prices since 2015 is much higher than the increase in incomes in many European countries (e.g. the UK, Luxembourg, Germany, Denmark and so on) and also many developing countries.
The house prices in the US have also lost the relation to rents (which means the income the house produces for the owner if he rents it out), as can be seen here.
If we look at the stock market, something similar is happening as can be seen in the chart below (which we have borrowed from the multpl.com website).
Source: https://www.multpl.com/shiller-pe
The chart shows the so-called ‘Shiller Price-Earnings ratio’, which is the price of a share divided by the average earnings of the company over the last 10 years (adjusted for inflation). As it can be seen, we are not at the level of the 2008 financial crisis yet, but we are very close.
Critics of this measure say that what matters is not what the company was earning the last ten years but rather what we expect it to earn in the coming years. This is true, but it is a more tangible measure than some lofty prediction of future earnings, so this index is widely used.
In conclusion, there are very credible signs that new bubbles are brewing and that these inevitably will burst at some moment.
However, it is difficult to say, when they will burst. This is so, because bubbles are formed when buyers are convinced prices can only go up. So it is very similar to a pyramid scheme. Everything is fine until enough people start having doubts whether this really can go on. When that happens, we can either have a gentle “correction” (where prices start coming down gently) or an abrupt fall (as in 2008). The longer the bubble is brewing, the higher is the probability that it ends in a collapse, which has severe repercussions for the wider, real economy and society.
We have seen several episodes recently, where the markets have jittered, but then the bubbles have continued building up. How long that can go on is a question of how long irrationality is fuelling the buyers and when doubts and fear takes over. The collapse is often triggered by some specific event. In 2008 it was the collapse of Lehman Brothers in the US. What the triggering event would be this time is impossible to say.
After the 2008 financial crisis, the governments in the larger developed economies did two things to contain the crisis: the central banks pumped liquidity into the banking system (plus the governments took over financial institutions that were deemed ‘too big to fall’) and the governments increased expenses to help avoid a collapse in demand (and hence production and employment). The pumping out of liquidity took from 2009 the form of “Quantitative Easing” or QE for short, where the Central Banks started buying up private and public bonds thus driving the interest rate down to (or close to) zero, paying with freshly printed money (electronically). This is a very unorthodox way of intervening, and has continued since, for more than a decade now. Old-school monetarists1) would say this would produce inflation, but it didn’t (not until now, at least). However, it is clear that the flooding of the economy with money and the close to zero interest rate have fuelled the demand for something that could produce a return on the money. And that has been mainly real estate and stocks (plus precious metals, art and a raft of stupid ‘assets’ as Crypto Currencies and Digital Art (NTFs)). So instead of pricking the bubbles, the Central Banks, which were supposed to stabilise markets, are destabilising them by continuing fuelling the bubbles.
The fact that Governments and Central Banks have considered it necessary to continue with QE for so many years after the 2008 financial crisis (and in the US a continued high fiscal deficit) tells us that there are some deeper problems in the international global economy, which are probably linked to the increasing inequality. It should come as no surprise that a redistribution from the poor to the rich suppresses private demand and hence Governments have to borrow money to keep up demand (private and public). For the moment the burden on Government finances from the increasing public debt to keep this circus going has been limited, as interest rates are so ridiculously low (in the US the interest rate on a 10 year government bond is less than 2% and with inflation running at 7%, investors have a negative real interest rate of -5%). But once QE is stopped, interest rates will inevitably increase and then this will not be a free ride any more.
This may be the moment to fasten the seat belts.
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1) The economist Milton Friedman insisted that there was a close relationship between inflation and the amount of money in circulation (cash and bank reserves), so Central Banks should make sure the amount of money increased in tandem with the physical production so prices could be kept stable. He became influential during the Thatcher-Reagan neoliberal revolution and several Central Banks started to follow this quantity-of-money rule. It didn’t work however (Central Banks are not the only ones creating money), and after some time trying they instead started targeting inflation. When inflation was above the target level (most developed countries have a target of 2%), they would reduce money supply, and vice-versa. According to the ‘theory’, for which Friedman earned a Nobel Price, as QE has increased the money supply enormously, this should have led to increasing inflation, but it didn’t, only to inflation in the price of assets (real estate, stocks etc.). As one Central Banker wrote (after 3 years of QE): ‘What’s wrong with our tried-and-true theory?’
According to Friedman, who studied the 1930 economic crisis, the crisis could have been avoided if the Central Bank had increased the money supply sufficiently. So this was the first reaction of the Central Banks to the 2008 crisis. But it became very quickly clear that Friedman was wrong. This was not sufficient, so Governments in the developed countries increased government spending and/or lowered taxes so to stimulate demand (and by the way increase public debt). This is old-school Keynesian politics, which Friedman abhorred.
