Financial Bubbles:

What They Are and What

Should Be Done
CEPR Basic Economics Seminar
Dean Baker
November 10, 2005

Financial Bubbles: What They

Are and What Should Be Done
The Nineties Stock Bubble: The Secrets of
Simple Arithmetic
The Housing Bubble: You can always live in
an overpriced house
Bubbles Arent Cute: How bubbles harm the
economy
How the Fed Can Burst Bubbles
Holding the Experts Accountable

The Simple Arithmetic of the

Stock Bubble
Short-term (1 day to 5 year) stock returns are
unpredictable, largely random
Long-term stock returns can be predicted based on profit
growth and PE ratios
Forecasters (CBO, OMB, private forecasters) routinely
make profit growth projections, therefore it is very simple
to derive stock return projections
Stock returns have two components: capital gains (the
rise in share price) and dividend payouts (including share
buybacks)
Stock returns = capital gains + dividend payouts
DEFINITIONAL TRUTH

Projecting Stock Returns

Assume PE is constant through time then
capital gains equal the rate of growth in profit
Dividend payouts average 60% of profits limited
by the need for reinvestment
Dividend yields 60% of earnings yield (inverse
of PE ratio)
Therefore, stock returns = profit growth + 60% of
earnings yield

Stock Returns:
Normal and Bubble Years
Normal
Profit growth 3.0% a year, capital gains 3.0% a
year
Historic PE 14.5 to 1, implied earnings yield 7.0
percent
Dividend yield = 60% of 7.0% = 4.2%
Stock return = 3.0% capital gains + 4.2% dividend
yield = 7.2%

Stock Returns:
Normal and Bubble Years
Normal (7.2%)
Nineties Bubble Years
PE crossed 20 in 1996 and 30 in 1999, so earnings yield was
under 5% after 1996 and close to 3.0% in 1999
The dividend yield fell from 3.0% in 1996 (60% of 5%) to less
than 2% in 1999
Normal profit growth was 3.0% but 1996-2000 were near
cyclical peaks. CBO projected NEGATIVE real profit growth
from 1999 to 2019
In bubble years, projected stock returns would have been 2.03.0 percent from dividends, plus minimal capital gains,
depending on growth assumptions
Investors would receive much better returns from
government bonds

Projections If the Price to Earnings

Ratio Isnt Constant
If the PE ratio rises, then dividend yield falls, leading to ever higher PE

Price to Earnings Ratio

700

PE Ratio

600
500
400
300
200
100

If the PE falls, then capital gains are negative and returns are
far worse than if PE stays constant
A high PE guarantees low returns unless profit growth goes
through the roof

2077

2073

2069

2065

2061

2057

2053

2049

2045

2041

2037

2033

2029

2025

2021

2017

2013

2009

2005

2001

1997

How to Recognize a Housing Bubble

In the long run, house prices nationally have followed inflation
In the long run, house prices have risen more or less with rents (same market)

Unless some fundamental factor has changed, then the

run-up since 1997 is a bubble

The Realtors Fundamentals

Population growth its slower today than in prior decades
Rising incomes incomes grew far more rapidly in the 50s and
60s
Environmental restrictions on building the late 90s were
not the heyday of environmentalism (Republican takeover of
Congress and state houses)
Limited supply of land land has always been limited; what
happened to Internet removing restrictions of time and space?
Low interest rates if low interest rates explain the run-up,
then house prices will plummet when interest rates return to
normal
It is interesting to note that the fundamentals just started to drive
up house prices at the same time the stock bubble was pushing up
stock prices. (Stock wealth can lead to higher real
estate
prices, just as in Japan in the 80s)

Bubbles: National and Local

Housing markets are local, but there are common
factors
The collapse of the bubble will not hit every market
equally (the collapse of the stock bubble didnt hit
every stock equally) but virtually all markets are
likely to see price declines
Higher interest rates will likely lead to a collapse,
but overbuilding will eventually saturate the
market, even without an increase in interest rates

Bubbles and the Economy

Why They Arent Cute

How the Stock Bubble Harmed

the Economy
Misdirected investment companies with no real
future get billions to invest
Inflated stock prices conceal accounting fraud
(e.g., WorldCom, Enron, Global Crossing)
Consumer wealth effect people spend based on
stock wealth that is not there; they dont have retirement
savings when needed
Under-funded pension funds (e.g., Delphi, United,
Northwestern, etc.) as pension fund managers had
assumed bubble would last
Collapse leads to a demand gap (a.k.a. recession)
that is difficult to counteract

How the Housing Bubble

Harms the Economy
Overbuilding in housing due to bubble inflated
prices, resources that could have been better invested
elsewhere are spent constructing big homes
Consumer wealth effect people spend based on
housing wealth that is not there; they do not have
retirement savings when needed
Possible financial panic when bubble bursts,
secondary mortgage market (Fannie Mae and Freddie
Mac) could be in danger
Collapse leads to a demand gap (a.k.a. recession)
that is difficult to counteract.

How the Fed Can Burst Bubbles

It is the Feds job Greenspan intervened to
stem the stock crash in 1987. He intervened in the
unraveling of the Long-Term Capital Hedge Fund
in 1998. The stock and housing bubbles have gar
more impact on the economy than either of these
events
The Fed has regulatory tools margin
requirements on stocks, lending soundness on
housing.
Interest rates higher interest rates can burst
bubbles.

Fed Talk (or Treasury Talk)

The Best Weapon Against
Financial Bubbles
The Fed chair and the Treasury Secretary have
enormous audiences for their pronouncements
If either of them clearly laid out the rationale for a
stock or housing bubble (e.g., showed my charts) then
every investment manager and financial advisor in
the country would have to be familiar with the
argument.
Any investment manager or financial advisor who
simply ignored these arguments would risk being
fired and possibly sued for negligence.
Talk is cheap; why not do it?

Holding the Experts Accountable

It was possible (in fact easy) for any professional analyst to recognize
the stock bubble
It is possible (in fact easy) for any professional to recognize the
housing bubble.
Custodians get fired when they dont do their job; why dont
economists, financial analysts, investment managers, and policy
analysts? (Everyone else was wrong too doesnt cut it.)
The Congressional Budget Office and Social Security Administration
have consistently made stock return projections for Social Security
privatization that they cannot support.
CBO over-estimated projected revenues in 2000 by close to $1 trillion
over a ten year time frame (0.8% of GDP) because it assumed that the
stock bubble would persist indefinitely.
(No one was fired.)

Conclusions
It is possible to recognize bubbles financial
markets are not that mysterious
Financial bubbles cause enormous economic
damage far more than modest increases in
the inflation rate
The Fed and Treasury can and should act to
counteract bubbles
Economists, business, and policy professionals
who cannot see financial bubbles should find
another line of work

Reading List
Baker, D. and D. Rosnick, 2005. Will a Bursting Bubble Trouble
Bernanke? The Evidence for a Housing Bubble Washington, D.C.: Center
for Economic and Policy Research
[http://www.cepr.net/publications/housing_bubble_2005_11.pdf].
Baker, D. 2002. The Run-Up in Home Prices: Is It Real or Is It Another
Bubble? Washington, D.C.: Center for Economic and Policy Research
[http://www.cepr.net/publications/housing_2002_08.pdf].
Baker, D. 2000. Double Bubble: The Implications of the Over-Valuation
of the Stock Market and the Dollar, Washington, D.C.: Center for
Economic and Policy Research
[http://www.cepr.net/publications/double_bubble.pdf].
Kindleburger, C. 2000. Manias, Panics, and Crashes: A History of
Financial Crises. New York: John Wiley and Sons.
Shiller, R. 2005. Irrational Exuberance, Princeton, NJ: Princeton
University Press.

Financial Bubbles:
What They Are and What
Should Be Done
Dean Baker
baker@cepr.net
Center for Economic and Policy Research
www.cepr.net