Macroeconomic Analysis and Policy

Session:15
Prof. Biswa Swarup Misra
 Learning Objectives
▪ Characterising Overheating
▪ Characterising Speculative Asset Price Bubbles
▪ Asymmetric Overheating
Overheating
 Overheating
▪ The combination of rapidly increasing inflation
against a backdrop of high employment and
capacity utilization, and a recently strong period of
GDP growth, characterizes an overheated economy
▪ For the developed economies, an overheated economy may
have a GDP growth rate in the range of 4–7%, with
unemployment as low as perhaps 4% and overall plant
capacity in the range of 85–88%.
▪ Typically, in the US, a benchmark used by economists as a
sign of a tight labor market is the point when the number of
first-time applicants for unemployment insurance falls below
300,000 per week. (This was indeed the case in the late
1990s, but then as the economy slowed by 2001, the number
increased to well above 300,000.)
 Overheating
▪ Emerging economies usually have higher
sustainable rates of growth given their lower initial
levels of output, employment, and effective
capacity utilization.
▪ In the case of China and Southeast Asia in the
mid- to late 1990s, for example, GDP growth over
10% would just be considered a comfortable.
▪ Overheating in China occurred in 1995, when GDP
growth roared to over 15% with inflation raging at
nearly 20% a year, and then again in the late
2000s with growth over 11%.
Session 13 and 14 Biswa Swarup Misra
 Overheating
▪ In 1997–98, the Southeast Asian economies of
Thailand, Indonesia, Malaysia, Singapore, Hong
Kong all experienced different degrees of
overheating with average annual GDP growth
rates in the vicinity of 12%, and with enormous
SAP bubbles in their stock markets, real estate
prices, and IT and high-skilled labor sectors.
▪ In the UK, escalating real estate prices
convinced the central bank in 2000–01, and later
again by 2008, that a nasty SAP bubble,
signaling dangerous overheating, was about to
pop.
Session 13 and 14 Biswa Swarup Misra
 Signs of Overheating
▪ If AD is pulled still further to the right by ongoing stimulative
fiscal/monetary policies, we approach Ymax at ‘‘full
employment’’ and full capacity.
▪ Bottlenecks begin to develop, and the highly skilled and
specialized labor market is often the first to exhibit wage
pressure.
▪ Retaining experienced workers in this climate becomes a
challenge. Qualified workers become increasingly harder to
find.
▪ Larger sign-on bonuses now become necessary along with
a host of other perks such as stock options, and so on.
▪ And all this occurs despite the fact that newly hired workers
may not be as productive as the ‘‘first picks’’ hired when the
economy was operating belaow potential.
 Signs of Overheating
▪ Raw materials and commodities, beginning with
specialized inputs, now also come under excess
demand pressure. Overall costs begin to
escalate.
▪ The output growth for the economy starts rattling
against the maximum possible growth, Ymax, at
‘‘full employment’’ and close to operating at ‘‘full
capacity’’.
▪ The growth rate of GDP begins to slow down
due to this combination of operating at (or close
to) full capacity with fewer and less-productive
new workers.
 Signs of Overheating
▪ Accompanying this slowdown is an alarming rise
in the inflation rate, driven by higher labor, real
estate, and raw materials costs.
▪ This increase in inflation could be evidenced
either in conventional indices such as the CPI
and the GDP deflator discussed earlier, or, more
insidiously, in ‘‘proxies’’ of inflation called
speculative asset price (SAP) bubbles
SAP
 Tulip Mania
▪ The first recorded nationwide bubble is the "Tulip
mania". A period in Dutch history during which
contract prices for tulip bulbs reached extraordinarily
high levels and then suddenly collapsed.
▪ At the peak of the tulip mania in February 1637, tulip
contracts sold for more than 10 times the annual
income of a skilled craftsman, which is above the value
of a furnished luxury house in seventeenth-century
Amsterdam.
▪ Figure 1 shows the tulip price index during the 1636-37
period.
Tulip Mania
 Tulip Mania
▪ Tulip mania, Netherlands 1636-37, is one of the earliest
examples of extreme asset price fluctuations.
▪ Tulip bulbs became very popular and it was extremely
fashionable to own the rarest varieties.
▪ Price began to soar, peaking at over 5,500 florins (approx.
£25,000 today) in February 1637, before declining just as fast.
▪ Kindleberger and many other economists claim Tulip mania to
be clear evidence of a ‘bubble’ or ‘mania’ where speculators
(with no interest in tulip bulbs) began buying bulbs believing
that the high bulb price would rise even higher, therefore
profiting in the changes in price.
 Tulip Mania
▪ People were purchasing tulips at higher and higher prices,
intending to resell them for a profit.
▪ However,such a scheme could not last because tulip prices
were growing faster than income. Sooner or later traders
would no longer be able to find new buyers willing to pay
increasingly inflated prices.
▪ As this realization set in, the demand for tulips collapsed and
prices plummeted. The Dutch economy went into a deep
recession in 1637
▪ Although historians and economists continue to debate
whether the tulip mania was indeed a bubble caused by what
Mackay termed "Extraordinary Popular Delusions and the
Madness of Crowds"
 The Tulip Mania
▪ Mackay (1841, p. 107), people sold their other possessions to speculate in the
tulip market:

▪ ... [T]he population, even to its lowest dregs, embarked in the tulip
trade.... Many individuals grew suddenly rich. A golden bait hung
temptingly out before the people, and, one after the other, they
rushed to the tulip marts, like flies around a honey-pot. Every one
imagined that the passion for tulips would last for ever, and that
the wealthy from every part of the world would send to Holland,
and pay whatever prices were asked for them. The riches of Europe
would be concentrated on the shores of the Zuyder Zee, and
poverty banished from the favoured clime of Holland. Nobles,
citizens, farmers, mechanics, seamen, footmen, maidservants, even
chimney-sweeps and old clothes women, dabbled in tulips
 Bubbles
▪ Economists’ have different views on the definition, and
indeed the existence of bubbles, however Stiglitz
outlines the basic intuition as ‘if the reason that the
price is high today is only because investors believe
that the selling price will be high tomorrow - when
“fundamental” factors do not seem to justify such a
high price - then a bubble exists’ or more simply
‘prices are high now because they are expected to be
still higher later’.
 Ascertaining Worth of Stocks
▪ Traditionally it was relatively easy to value shares as the
majority of companies' assets would be physical, from land
to vehicles, and markets were fairly stable.
▪ Now, more and more assets are intangible (brand names,
human capital and innovation) making them much harder
to value.
▪ For example, Enron, previously seen as a trustworthy
company, lost all market value during the scandal 2001-
2002 as it lost the trust of investors and customers.
▪ The dotcom companies of the late 1990’s also stretched
the limits of intangible assets by putting a value on profits
that wouldn’t be realised until many years in the future and
brand names that weren’t established or didn’t even exist.
 Identifying Bubbles
By studying extreme asset fluctuations in recent years we can
see that there are certain factors which can be associated with
bubbles:
➢ a fall in savings rates,
➢ unusually low inflation,
➢ unusually high growth,
➢ a rise in money supply and
➢ a deteriorating current account.
▪ Bubbles can also occur as a result of technological change
(e.g. internet and the dotcom bubble) or cheap credit
(unusually low interest rates).
 SAP Bubbles
▪ Examples of Speculative Asset Price (SAP)
bubbles are the spectacular increases in stock
prices, as in the NASDAQ in the US in the late
1990s.
▪ The “irrational exuberance” in the US stock market
may have led to dangerous SAP bubbles in
equities-primarily in the technology sector-and in
real estate, contributing to an overheated US
economy by 1999
▪ Irrational exuberance is a term is Chairman
Greenspan's now-famous comment made in 1996)
 SAP Bubbles-Characteristics
▪ Other examples of SAP bubbles are the equity
markets of Southeast Asia in the early 1990s, and
in Japan in the late 1980s.
▪ Housing prices in Singapore, Hong Kong, the US
(till 2007), the UK and, of course, Ireland, in the late
2000s, are perfect examples.
▪ Beijing and Shanghai (along with other urban areas
in China) incurred dramatic spikes in property
prices as personal investment promoted by hot
Capital inflows, excessive liquidity created by the
PBoC, runaway speculation, and unfettered bank
lending to the private sector surged by late 2014.
 Why SAP Bubbles are difficult to Discern
▪ Why aren’t these alleged SAP bubbles captured
by conventional indexes?
▪ And when SAP bubbles do exist, why can’t
individuals spot the warning signs before the
bubble bursts?
▪ Why do we need the central bank to be the self-
appointed guardian against such speculative
crises?
 SAP Bubbles
▪ SAP bubbles may not be fully captured by national inflation
indexes such as the deflator and the CPI because
speculative bubbles are often confined to very specific
sectors, and often to very specific geographic parts of the
economy.
▪ Typically, bubbles are caused by a surge in liquidity.
Rampant monetary creation, results in all the capital rushing
to one/few champion sectors in the absence of many
investment opportunities.
▪ This fuels a run-up in price that escalates as other investors
attempt to ride the high-flying asset and desperately bid
more for the privilege of doing so.
 SAP Bubbles-Characteristics
▪ In addition, with the mature economies moving further
away from conventional manufacturing, traditional
inflation measures designed to capture increases in
costs of raw materials, transportation, storage, and
power consumption, etc., may not accurately reflect
overheating in a predominantly service-oriented
economy.
▪ In fact, the only hint of overheating in such a service
based economy may be astronomical salaries (plus
stock options, flexible hours, child care, etc.) as
employers compete for the dwindling pool of highly
skilled workers.
 SAP Bubbles-Characteristics
▪ Associated with this bubble were astronomical salaries
and benefits that were necessary to attract highly skilled
employees in sectors such as Information Technology
(IT) and e-commerce, biotechnology, etc., in the US,
Ireland and the UK from the mid-1990s till 2000.
▪ In the US, the technology bubble of the late 1990s gave
way to the liquidity-induced “bubble multiplier,” one
bubble in dotcoms led to three bubbles by 2006, namely
(i) real estate,
(ii) mortgage-backed securities drive by the ‘‘sub-prime
mess,’’ and
(iii) a massive bubble in private credit card debt.
 Why SAP Bubbles are Difficult to Diffuse
▪ Speculative asset price bubbles are considered to be “more
dangerous” because while they may develop in a few
specific sectors such as equities, real estate, commodities,
and high-skilled labor, the overall national rate of inflation as
measured by conventional indexes may not be signaling any
proportional escalation of inflation!
▪ For example, in the US and Southeast Asia, as the stock
prices, the IT salaries, and real estate prices were in the
stratosphere in the mid to late 1990s, overall rates of national
inflation remained deceptively benign.
▪ For example, when Fed Chairman Alan Greenspan attacked
the dotcom bubble in 2000 with four interest rate hikes, it
should be noted that the overall national inflation rate was
only 2.2 %! Dotcoms were SAP bubbling while the overall
economy was not experiencing high inflation.
Asymmetric
Overheating
 Why SAP Bubbles are Difficult to Diffuse
▪ Similarly, when China had massive SAP bubbles in
housing in the mid-2000s, at times its overall inflation
rate was almost negative! This is the relatively recent
phenomenon of asymmetric overheating; one sector
goes into SAP bubble mode while the rest of the
economy remains benign and calm.
▪ These sector-specific bubbles have made it especially
challenging for central banks to isolate them and soft-
land them.
▪ Monetary policy is a blunt instrument; a monetary
contraction that pushes short-term interest rates up will
hammer the whole economy, not just the overheated
sector or sectors.