Fighting Bubbles: High Interest Rates Are Not The Best Route

Ruchir Sharma, the chief global strategist at Morgan Stanley Investment Management, used his NYT column to argue that central banks have to include fighting asset bubbles on their agenda, in addition to promoting high employment and low inflation. As someone who has argued this for two decades, I am sympathetic to the point, however Sharma gets a couple of big things wrong.

First, the big issue with bubbles is whether they are moving the economy. This is something that is easy to determine for folks familiar with introductory economics. The issue here is whether some component of demand is out of line with its long-term trend.

That was easy to see in the late 1990s as the wealth created by the stock bubble led to a consumption boom, pushing the saving rate to a then record low. The investment share of GDP also became unusually high, with investment concentrated in the tech sector where stock prices were most out of line with corporate profits. 

The same was true of the housing bubble in the last decade. Residential construction hit a record 6.5 percent share of GDP, a level that clearly did not make sense given the underlying demographics of the country. The wealth effect from bubble created housing wealth led to an even larger consumption boom than the 1990s stock bubble, as savings rates fell even lower than they had in the late 1990s. It is difficult to understand how the Fed could have missed the impact of the bubble or think that these sources of demand could be easily replaced when the bubble burst.

At present, there is some modest evidence that high stock and housing prices are having some effect in pushing consumption to unusually high levels. The personal saving rate has fallen to 3.7 percent in the most recent quarter, compared to a more normal 5-6 percent rate. (Bizarrely, many economists and economic reporters were genuflecting over why the saving rate was at a reasonable 5-6 percent in the years immediately following the crash, failing to recognize that consumption had simply returned to its normal level as a share of income.)