Why current asset prices are dangerously exaggerated

Published in Real Clear Markets.

Over the long term, real per-capita household net worth in the United States has grown at about 2 percent a year. This is a wonderful achievement of the enterprising economy.

In shorter periods, when asset prices get inflated in a bubble, household per-capita wealth appears to rise notably above this long-term pace, but ultimately, bubble asset prices inevitably shrivel. When they do, many commentators claim that a lot of “wealth” been lost by households. It hasn’t, because the apparent wealth was not really there in the first place: it was an illusion of the bubble.

If any very great number of people try to sell out at the bubble prices, the evanescent “wealth” disappears, the bubble deflates and the long-term trend reasserts itself, so the aggregate bubble prices can never be realized. Bubble times reflect what Walter Bagehot so truly wrote in 1873: “All people are most credulous when they are most happy.”

Graph 1 is the record of 1953 to 2016. The temporary illusion of wealth represented by two remarkable bubbles of recent decades is obvious.

We should recall with amused irony that the central bankers formerly congratulated themselves for creating what they credulously called “The Great Moderation.” What they actually presided over was the Era of Great Bubbles: first the Great Overpaying for Tech Stocks in the 1990s, then the Great Overleveraging of Real Estate in the 2000s.

And now? They are congratulating themselves again for innovative or radical monetary actions, including their zero interest rate policy (ZIRP), which expropriates the returns to savers and makes the present values of assets rise. Many observers, including me, think they have by their manipulations inflated new bubbles in stocks, bonds and houses. This has put real household wealth per-capita measured at current asset prices back over its 2 percent growth line, although not as egregiously as in the government-promoted housing bubble of the last decade. We can expect ultimate regression to the trend, as always.

But has the trend shifted? From 1950 to 2000, growth in U.S. real per-capita gross domestic product averaged more than 2 percent per-year. This is consistent with a 2 percent growth in wealth per-capita. But since 2000, real per-capita GDP has grown less than 1 percent per-year. Suppose the stagflationists are right, and this represents not a temporary, but a sustained downshift. Then it would be consistent with real per-capita economic growth to move our trend growth in real net worth per-capita down to 1 percent. Graph 2 shows the possible new trend line, starting in 2000.

If we measure from this new line, the current ZIRP bubble looks much worse; it has reached almost the same magnitude as the infamous housing bubble of a decade ago.

Graph 3 shows the variation from the 2 percent and 1 percent lines, displaying the illusory household wealth effects of the series of bubbles in a different fashion.

The more you believe the stagflationist theory, the more you must conclude that current asset prices are dangerously exaggerated, the greater the bubble you must conclude that the central bank experiments have wrought and the further we have to fall back to the trend.