- High asset prices used to be associated with optimism. Today, they are a sign of pessimism.
- This is because investors have wised up to economic stagnation and to the true sources of sustainable profits.
Asset price bubbles are not what they used to be – which tells us something about the economy.
Historically, bubbles have been associated with optimism and even utopianism. In his classic The Great Crash 1929 JK Galbraith described how the bubble of the 1920s was fuelled by “boundless hope and optimism.” 1928, he wrote, “was the last year in which Americans were buoyant, uninhibited and totally happy.” Similarly, bubbles in internet stocks in the late 1990s or railway stocks in the 1840s were accompanied by the idea that new technologies would transform society and the economy and investors bought into them in part because they thought they were getting a piece of a better future.
High asset prices today, by contrast, are founded not upon optimism but pessimism. High valuations of US big tech companies owe a lot to the belief that their monopoly power is entrenched and persistent. That betokens a pessimism about the strength of competition and creative destruction, which are the forces that have traditionally fostered economic growth. And the now-faltering boom in cryptocurrencies is founded in part on expectations that people will lose faith in “fiat money” – something which is only likely (if it happens at all) in a horrible political and economic crisis.
Even high house prices are in part a sign of pessimism. For one thing, they’ve been driven up largely (if not entirely) by low interest rates which are themselves a symptom of economic stagnation. My chart shows that as real interest rates have fallen since the 1980s so the ratio of house prices to earnings has risen. And the fact that people use cheap money to buy housing rather than productive assets is itself a sign of a dearth of investment opportunities.
What’s more, as Willem Buiter, a former MPC member, has said, housing is not net wealth. Higher house prices merely transfer wealth to home-owners and away from prospective buyers and renters. In this sense, rising house prices are unlike rising share prices, which (if sustained) do betoken increases in genuine wealth.
What we’ve seen, then, is an important but overlooked change. Whereas bubbles used to be associated with hope, they are now associated with pessimism.
This isn’t to say there are no technical breakthroughs now. There are. Our escape from the pandemic is due to developments in messenger RNA, and green energy offers much hope. One reason why investors should consider private equity funds is that they give us early exposure to companies using such technologies.
Equally, therefore, many technologies not (yet?) enriched equity investors. 3D printing, the internet of things, neural networks and graphene have been discussed for years but few of us have seen the benefit in our portfolios.
In one sense, pessimistic bubbles are a sign that investors have wised up. The mistake they made in the internet bubble was what New York University’s Aswath Damodaran has called the “big market delusion”. They correctly saw that internet shopping would be a big thing, but drew the wrong inference from this – that many firms would benefit from this. In fact, competition for the market, ease of entry into it and difficulties in expanding meant that many never made profits and went bust. As the Nobel laureate William Nordhaus wrote, “most of the benefits of technological change are passed on to consumers rather than captured by producers.”
Investors have now largely corrected this error. They now know that what matters most for a company is not the size of its potential market but rather its market power – its ability to convert such growth into profits. Hence the high valuations of companies with monopoly power – be they as otherwise different as Microsoft (US:MSFT), Diageo (DGE) or Games Workshop (GAW). Investors have shed their illusions about capitalism: they now realize that what matters is the bottom line, not romantic stories about “the rapid improvement of all instruments of production.”
This recognition of the importance of monopoly, however, is the counterpart to stagnation. As New York University’s Thomas Philippon has documented, the decline of competition and rise of monopoly is one cause of the US’s slower long-term growth – hence the demise of bubbles based upon optimism.
Which is a particular instance of what Northwestern University’s Joel Mokyr has called Cardwell’s law (named after the economic historian Donald Cardwell): “every society, when left on its own, will be technologically creative for only short periods.” Eventually, he wrote, “the forces of conservatism” slow down creativity as they preserve their own power and privilege – in this case by entrenching monopoly power. In a world where the forces of conservatism have prevailed, we are less likely to see optimistic, growth-based speculation.
Perhaps every society gets the bubbles it deserves – and ours has some dystopian ones.
