Andrew Smithers blames the global financial crisis on “the actions of incompetent central bankers.” He argues that central banks’ targeting asset price bubbles may result in occasional minor recessions. But doing so can also prevent asset price collapses that trigger deeper economic downturns. His argument warrants serious consideration.
Andrew Smithers blames the global financial crisis on “the actions of incompetent central bankers” in his Wall Street Revalued: Imperfect Markets and Inept Central Bankers. Specifically, he writes, “If the agreed policy of central banks had been to restrain asset bubbles, and they had acted to do so, the current pain could—and probably would—have been avoided.” Smithers argues that central banks’ targeting asset price bubbles may, from time to time, result in minor recessions, such as those of 1990–1991 and 2001. But doing so can prevent asset price collapses that trigger deeper economic downturns, such as those of 2008–2009 and the Great Depression.
A London-based financial consultant who is frequently cited in the Economist, Smithers was among a handful of market observers who called the top of the equity bubble in March 2000. His argument warrants serious consideration. Indeed, his book has much to recommend it.
Smithers makes the case that the stock market is not perfectly efficient, but neither are stock prices entirely random. Reality lies somewhere in between, making the market “imperfectly efficient.” The notion that financial markets are not perfectly efficient is consistent with the more widely accepted observation that the broader macroeconomy is not perfectly efficient, either.
According to Smithers, one reason that central banks do not target asset price bubbles is that they believe assets cannot be objectively valued, a belief that Smithers does not share. To value equities, he uses an equity q ratio (the market value of the nonfinancial corporate sector divided by its net worth at replacement cost) and the 10-year cyclically adjusted price-to-earnings ratio (used by Robert J. Shiller in Irrational Exuberance [2000]). These two very different valuation methodologies lead to similar results, reinforcing the validity of each. To value residential real estate, Smithers uses the ratio of housing prices to incomes. The third gauge that he believes central banks should monitor is relative corporate credit spreads as a reflection of risk aversion and liquidity conditions in the financial markets.
Stock prices affect the real economy through their impact on household savings rates. In the long run, Smithers finds, no stable empirical correlation exists between the level of either real or nominal interest rates and future equity returns. Long-term equity returns are driven not by interest rates but, rather, by stock prices in relation to underlying corporate earnings. In the short run, however, changes in interest rates do affect stock prices, making the stock market an important transmission mechanism by which monetary policy affects the real economy.
Stocks may become overvalued from time to time, but stock prices eventually tend to revert to their mean. Because financial intermediaries base most of their lending decisions on asset prices, the bursting of an asset price bubble prompts them to reduce their extension of credit much more than they do during run-of-the-mill recessions. This contractionary effect overwhelms the short-term expansionary effect of monetary easing. Therefore, the more asset prices escalate beyond their intrinsic value, the less impact monetary policy will have on them—and thus on the broader economy—once the bubble bursts. To avoid losing control over their economies, Smithers argues, central banks should prevent asset prices from reaching levels from which they will inevitably fall in the first place.
The implication of this discussion is clear: If only the Federal Reserve had recognized and deflated the stock market bubble in the late 1990s, there would have been no housing bubble in the first decade of the 21st century and no global financial crisis after the housing bubble burst.
Smithers is correct in asserting that some intrinsic value can probably be determined, such as the value derived by discounting expected future cash flow streams. But intrinsic value is not straightforward. Honest analysts can disagree in their expectations of those future cash flows and on the question of which discount rates and multiples to apply. Hence, we have the phenomenon that during an asset price bubble, many credible observers argue persuasively that a bubble is forming while many other credible observers argue equally persuasively that warnings of a bubble are much overdone. To add to the confusion, credible observers sometimes argue that a bubble is forming when, in fact, it is not. At the very least, intrinsic value is probably a range rather than a specific number.
Smithers is also correct that the market at times appears to stray far from that range, making it either “rich” or “cheap.” Perhaps the most persuasive explanations to date are offered by those in the field of behavioral finance. These arguments include such factors as pure naive greed or the more sobering prospect of losing one’s job or client business in the event of relative underperformance in the short run even if one’s belief that the market is overvalued proves correct in the long run. The efficient market hypothesis does not incorporate such behavioral aspects, whether they be rational or irrational.
Still, an important reason that the efficient market hypothesis refuses to be debunked is not that financial economists are unwilling to revise their theories in light of new evidence, as Smithers argues, but rather that its most important prediction is borne out in reality. That prediction is that consistently outperforming the market is extremely difficult; therefore, most investors are better off buying low-cost, index-replicating investment vehicles rather than expensive active investment management services.
In practice, the inability of investors to exploit asset price bubbles—assuming they can accurately recognize them in the first place—casts doubt on the notion that central banks possess the ability to deflate them. Smithers recommends that central banks maintain their existing practice of using short-term interest rate policy to target consumer price inflation while varying banks’ minimum capital ratios to offset their tendency toward procyclical lending behavior that leads to asset price bubbles. His proposal is reminiscent of the idea that the Federal Reserve could nip stock price bubbles in the bud if it curtailed stock market speculation by increasing margin requirements. This idea has received considerable attention in the literature, but no broad consensus about its validity yet exists. Still, after the widespread damage done to the financial markets and the real economy in recent years, all serious proposals should be on the table for evaluation, including the one offered by Smithers.
—J.H.T.