Interesting paper from the San Francisco Fed by Òscar Jordà, VP Economic Research at the San Francisco Fed, Moritz Schularick, professor of economics at the University of Bonn, and Alan M. Taylor, professor of economics and finance at the University of California, Davis. They discuss the difficulty in identifying asset bubbles and the relationship of asset bubbles to credit.
A defining feature of advanced economies in the post-World War II era is the rise of credit documented in Jordà, Schularick, and Taylor (2016). This is visible in Figure 1, which displays the cross-country average ratio to GDP of unsecured and mortgage lending since 1870. Following a period of relative stability, both lending ratios grew rapidly after the war, with mortgages taking off in the mid-1980s….
Most buyers use mortgages to buy homes, but few savers use borrowed funds to invest in the stock market. Thus, one might expect equity price busts to be less dangerous than collapses in house prices: A crash in the price of assets financed with external (rather than internal) funds is likely to have deeper effects on the economy. As collateral values evaporate, some agents will delever to reduce their debt burden, in turn causing a further collapse in asset prices and in aggregate demand. The more widespread this type of leverage is, the more extensive the damage to the economy. Integrating the role of credit into the analysis of asset price bubbles is therefore critical.
Anna Schwartz discussed the issue in a 2008 interview with the Wall St Journal. Then 92 years old, the co-author with Milton Friedman of A Monetary History of the United States (1963) nailed the cause of asset bubbles:
If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates …..
The problem is not asset bubbles, whether they be in stocks, housing or Dutch tulips. That is merely a symptom of a deeper malaise: too easy monetary policy. The threat is the underlying credit expansion that caused the problem in the first place.
And while asset bubbles may be difficult to measure, credit bubbles are easy to identify. If credit grows at a faster rate than GDP, that is a credit expansion. The ratio of credit to GDP should be maintained in a narrow, horizontal band.
Easy to monitor and easy to correct, if the Fed is looking in the right place. But central banks are good at looking elsewhere — and closing the gate long after the horse has bolted. A similar problem is evident in Australia.
Even worse if we look at household credit to disposable income (on the left below).
Unfortunately the horse has bolted and attempting to contract the level of debt would cause a deflationary spiral with devastating consequences. The only way to restore sanity is to hold debt steady at current (nominal) levels and allow growth and inflation to gradually reduce the GDP ratio to more stable levels.