Quentin Grafton is Director of the Centre for Water Economics, Environment and Policy (CWEEP) at Crawford School of Public Policy. In April 2010 he was appointed the Chairholder, the UNESCO Chair in Water Economics and Transboundary Water Governance.
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Quentin Grafton connects the dots between policy decisions and asset price bubbles.
Lessons about global economics can sprout from some pretty unexpected places. Such as the price of tulips in the 17th Century, in what is now known as the Netherlands.
Riding a crest of a popularity based on speculative demand, the price of tulip bulbs reached sky-high levels in 1636 and 1637– some bulbs selling for 10 times the annual income of a skilled craftsman – and then collapsed. This notorious incident went down in history as Tulip Mania, and is one of the Western world’s first recorded incident of an asset price bubble.
Asset price bubbles are still a persistent problem today. What to do about them is a big challenge for policymakers.
An asset price bubble exists when the market price of an asset trades far above its ‘fair market value’. For many people, the market price is its fair market value. Thus, an asset is worth whatever someone is prepared to pay for it.
The problem with defining fair market value as the market price is that this reasoning is circular; price determines fair market value and fair market value determines price! We need some objective measures, other than simply the market price itself, to determine whether there is a price bubble.
A common way to assess fair market value is to calculate yields, or returns from the asset as a proportion of its market price, such as an earnings-to-price ratio, and how this changes over time. The idea is that if yields are declining rapidly, or are approaching historic lows, then this may indicate that the market price is approaching historic highs. This might indicate overinflated market prices relative to fair market value.
The challenge of using a yield measure is that it also depends on the market price. Further, yield depends on the relative risk of owning the asset which is typically calculated by an asset’s price volatility. Consequently, a falling yield may represent a decline in the relative riskiness of holding the asset or risk aversion by investors for that asset which, in turn, may justify the asset’s higher price. Measuring perceived risk or risk aversion of investors for a particular asset class is difficult and, thus, so too is assessing fair market value from a measure of yield alone.
Another way to assess fair market value is to compare the asset price to broader underlying measures of the economy. For example, the ratio of residential housing prices to average income gives some indication of relative house affordability which, in turn, gives a rough-and-ready indicator of fair market value. Thus, a historically high price-to-income ratio might provide evidence in support of market prices in excess of fair market value.
Another challenge when assessing whether the current price of an asset exceeds its fair market value is that the current price is based on investors’ expectations of the future changes in the market price of the asset (and investment alternatives), as well as the asset’s current and expected yield.
For example, many penny stocks pay no dividends and are owned by investors simply for what they expect to receive in terms of capital gain, or the expected increase in the market price. Other assets, such a property owned by investors, are owned both for both their yield (rent on the property) and the expected increase in the property’s price.
As the future is not knowable, so long as the expected increase in the market price continues, the underlying market price can be justified as its fair market value because the capital gain is sufficient to justify the current price, and investors will continue to demand the asset at that price. The problem arises when the expected capital gain is not justified by any underlying value or scarcity. In such cases, asset prices can fall dramatically because, if eventually most investors no longer believe the capital gains (price increases) will continue, then they will start to exit the market and sell the asset. This, of course, reinforces their belief that prices will fall.
Price behaviour where high market prices can only be justified by investor sentiment of further price increases, and not any underlying return from the asset, other than a capital gain, is called a ‘speculative price bubble’. The Tulip Price Bubble was just one example of countless over the centuries.
So what does this all mean for public policy?
First, asset price bubbles are not just a ‘made-in-the-market’ phenomenon, but are fundamentally affected by decisions made by policymakers. Decisions such as interest rates, and rules and regulations about borrowing, and how returns on assets are taxed. For instance, part of the explanation of the more than 70 per cent increase in the Shanghai Stock Exchange Composite Index over the past year are changes in how Chinese investors can borrow to invest in the market. Asset price bubbles, typically, also coincide with periods of rapid credit expansion and financial bubbles that are related to macroeconomic policy decisions.
Second, the bursting of financial bubbles, as occurred at the height of Global Financial Crisis in 2008, can impose major and negative impacts on the real economy (income growth, unemployment), and not just asset prices.
One of the ways this happens is that, typically, financial institutions are highly leveraged and when a financial bubble bursts they are left with much reduced (or even negative net worth) which can cause a temporary liquidity crisis and longer term loss of business and consumer confidence. Price collapses, particularly in more liquid assets such as shares, can also be easily transmitted across asset classes and countries causing global effects.
Third, asset price bubbles are likely to be much more problematic in a low-inflation environment. This is because real prices declines are much more likely to be associated with nominal price declines. In turn, this raises the possibility of deflation if important asset classes (such as property) were to substantially drop in price.
Countries which have high debt-to-income ratios, such as Australia, are also more vulnerable to the bursting of price bubbles. For instance, Australia’s household debt-to-income ratio is at an historic high at about 1.8, and in 2012 it was about twice that of Italy or Germany, and greater than for any large developed economy, including the US and Japan.
There are no easy answers for policymakers tackling asset bubbles. But if economic history teaches us anything it’s that the lessons of the past should make us wake up and ‘smell the roses’.
Useful Follow Up:
A classic text on price bubbles is a book by Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics and Crashes: A History of Financial Crises. A contentious book on price bubbles, focussed on Australia’s property market, is Bubble Economics: Australian Land Speculation 1830-2013 by Paul F. Egan and Philip Soos.