First, an economy-threatening bubble does not just sneak up on us. Often the discussion of bubbles implies that we need some complex measuring tools to uncover an economy-threatening bubble that’s lurking in some far corner of the data.
This is absurd on its face. If a bubble is large enough to threaten the economy, it is hard to miss. This was true of both the stock bubble in the 1990s and the housing bubble in the last decade.
In the case of the housing bubble, inflation-adjusted house prices had risen by more than 70 percent above their long-term trend. This unprecedented run-up in house prices occurred at a time when rents were essentially moving in step with the overall rate of inflation, suggesting that there was no major shift in the fundamentals of the housing market. Furthermore, vacancy rates were already at record highs even before the bubble burst, providing clear evidence that house prices were not being driven by a shortage of housing.
Should we be concerned about a bubble now? Stock prices and housing prices are both high by historical standards. The ratio of stock prices-to-trend corporate earnings is more than 27-to-1; this compares to a long-term average of 15-to-1.
House prices are also high by historic standards. Inflation-adjusted house prices are still well below their bubble peaks, but are about 40 percent above their long-term average.
In both cases, these markets are high, although in ways that are at least partly explained by the fundamentals of the market. In the case of stock prices, the profit share of GDP is almost 30 percent above its trend level. If this persists, then the ratio of prices-to-earnings is much closer to the long-term average. Of course, a big cut in the corporate tax rate increases the likelihood that a high-profit share in GDP will continue.
The run-up in house prices also seems less disconcerting when we consider there has been a parallel run up in rents. While rents have not increased as much as house prices, they have been substantially outpacing the overall rate of inflation for the last five years. Low-interest rates would also help to explain house prices being above long-term trends, as they justify a higher ratio of sales prices-to-rents.
Here also, there is a risk that higher rates could send prices tumbling. This could be an especially bad story for moderate-income homeowners, since the bottom tier of the housing market has seen the largest price increases over the last five years.
But even in a bad story, where for example higher interest rates send both stock and house prices back towards their trend levels, we don’t have to fear an economic collapse and probably not even a recession. The high stock market is not driving investment, which remains very modest despite near record-high after-tax profits. Housing construction has come back from its post-crash lows, but is roughly in line with its long-term average share of GDP.