On 8/29/2011 9:07 PM, Mike Beggs wrote:
>>So when I say that there is not an absolute point
>>at which 'profitable' turns into 'unprofitable', and that
>>"profitability is a complex thing, and always relative
>>to other returns", I think it's an answer to your point
>>here:
>>>Okay, but it doesn't follow automatically that
>>>disappointing rates of return to money-capital
>>>will result in a greater (system-wide) appetite for
>>>risk. I mean, if you think of a classic case of a
>>>deeply depressed economy, the rates of return
>>>are disappointing but people *flee* from risk.
>>This is a difference between a period where a
>>sector or sectors are expected to outperform
>>generally disappointing other returns, and a period
>>in which nothing is expected to outperform, or in
>>which people value capital safety and liquidity
>>higher.
>[...]
>>I don't see that the two arguments are
>>incompatible. Clearly a lot of people had to
>>believe real estate returns would outperform
>>those of other potential assets for them to put
>>their financial resources into it. But the gap can
>>begin to open up either because expectations
>>for real estate spontaneously rise, or because
>>expectations for the alternatives fall. And the
>>reason why the gap is sustained might be
>>different from why it opens up in the first place
>>- because asset market movements tend to
>>develop momentum.
On Tue, Aug 30, 2011 at 10:12 PM, SA <s11131978 at gmail.com> wrote:
>
> Aha - now I see what you were getting at! I was missing this point.
>
> I guess my response is that this is correct as a *general principle*: All
> bubbles, throughout history, have been focused on some particular sector. So
> yes, by definition that means a gap has opened up between returns in this
> sector (whichever one it is) and returns in the other sectors - and
> therefore, it becomes possible *in theory* to argue that the first cause of
> the divergence was "too low" returns in other sectors, rather than "too
> high" returns in the bubble sector.
>
> In response, I'd say three things.
>
> First, in practice it seems very unlikely to me that a bubble in a
> particular sector can start simply because returns in other sectors have
> fallen. It just doesn't seem to match up with the typical bubble narrative.
> For one thing, if there was a decline in returns to other sectors, why was
> the bubble sector spared from this decline in the first place? Take the
> housing sector, for instance. In a given local real estate market, when
> returns to other industries fall, returns to housing almost always fall in
> response. Think about the local property market in rust-belt-type areas like
> Michigan. In the US, those areas were never touched by the housing bubble -
> precisely because returns in other local sectors (e.g., mfg) were too low to
> support bubble-like expectations for the housing market. And this type of
> story is even less plausible for other types of bubbles, which usually focus
> on some *new* fast-growing sector. Could anyone really argue that the reason
> people poured insane money into internet companies in the 90's was simply
> that other sectors were disappointing? No - it was because the internet was
> a genuinely promising new sector. (Although not quite so promising as to
> fully justify valuations.)
Think about it this way. Let's start from a position without a bubble; i.e. assets are generally valued so as to equalise the present value of expected risk and liquidity-adjusted returns, and those expectations are reasonable. Now, for some reason, the pace of lending the financial system can sustain picks up faster than the 'warranted' rate of capital accumulation which would maintain the going rate of return. Maybe there is a shift in attitudes towards taking on more risk; maybe there is financial innovation that allows some intermediary to assume more risk; maybe the cost of bank reserves becomes cheaper due to monetary policy; maybe there is increased growth rate of foreign demand for domestic financial assets.
Competition drives financial institutions to expand their lending; they are indifferent as to where they lend to. Let's say firms in general are not prepared to take on more debt to finance expansion because internal funds are sufficient given their expectations of potential future revenues. Instead, the marginal borrowers are household mortgagees; some perhaps are induced to expand their borrowing at lower rates, others are considered newly creditworthy. The borrowers bid against one another for the housing stock and begin to drive up prices/expand the stock, especially since there is a particularly high multiplier effect in expenditure on housing, because people who sell tend to plough the proceeds back into another property. Expected rental yields fall but price rises raise expectations for capital gains in housing. A bubble now begins, as higher expectations of capital gains increase the present value of real estate.
This glosses over a lot of tricky issues but you get the general idea.
>
> Second, given the point I make above, it seems that to make your argument
> really convincing one would have to make a case that returns in the other
> sectors were "too low" in some *absolute* sense. You'd have to show, for
> instance, that returns in the non-housing sectors in the 2000's were
> exceptionally disappointing. But I'm sure one could easily point to other
> historical periods when non-housing returns were just as low or lower than
> in the 2000s without producing any bubble in housing.
In the example above, it's not necessary that non-housing returns be especially disappointing, just that they not rise as fast as financable demand for the assets they are connected to.
Again, I'm not trying to argue that these processes were actually happening in the 1990s-2000s - it would take a lot of detailed empirical work. It's just a hunch I'm not all that committed to, but I do think the processes are not only logically coherent but could at least plausibly be at work in certain conditions in a capitalist economy.
> So although I acknowledge that your scenario is theoretically consistent, I
> think the opposite scenario seems much more plausible: It was *rising*
> returns in the real economy that triggered the initial episodes of house
> price appreciation that then formed the psychological basis of the bubble.
> The capital markets absorbed the psychology and *responded* to price growth,
> propagating the bubble further, even after the initial shock had dissipated.
I think this is similar to the question of whether a fire is caused by the presence of oxygen, the fuel, or the spark. All are necessary.
Mike