Economic Bubbles and the Myth of High Returns

Stock prices are soaring now, but a price drop of 10-20% is a real possibility, says economist Dean Baker

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Story Transcript

SHARMINI PERIES: It’s The Real News Network. I’m Sharmini Peries coming to you from Baltimore.

The dot com bubble was an historic economic bubble and a period of excessive speculation that occurred roughly between 1997 to 2001, a period of extreme growth in the financial markets not unlike today. When that bubble crashed it sent markets and regulators spinning, asking how can this be avoided in the future. Many people lost their life savings. But then in 2007-2008 we had the housing bubble that crashed, leading us to what is called the Great Recession now. Many people lost their homes and their savings. Generally an economic bubble refers to a situation where the price of an asset exceeds its fundamental value by a large margin. So during the bubble, prices for a financial asset are highly inflated. Now, with the recent record prices in the market that President Trump attributes to his good business sensibilities strengthening the economy, even with these big single one day drops that we ‘ ve seen in history the market prices are still inflated and very high, so everyone is asking, is there another bubble coming?

On to discuss this with me is economist Dean Baker. Dean is the co-director of the Center for Economic Policy and Research, and is the author of “Rigged: How Globalization and the Rules of the Modern Economy were Structured to Make the Rich Richer.” Welcome, Dean.

DEAN BAKER: Thanks for having me on.

SHARMINI PERIES: Dean, recently we have seen the biggest one-day drop in the markets in history. And yet the prices-to-earnings ratios which lead to even more speculation is causing stock prices to remain very high. Does this mean there is another bubble pending?

DEAN BAKER: Well, there’s a few things that could be said. First off, the market is definitely high. So if you look at historic valuations, the ratio of stock price to corporate earnings, somewhere around 25. You could use different measures, some measures would give you a higher number. But in any case it is certainly high by historic standards. Just a point of reference, the average over a long period, say the last 78 years, is about 15. So stock prices are definitely high.

One takeaway, I guess two takeaways from that one, is you can’t expect when stock prices, the ratio of prices to earnings are 25:1, you can’t expect the same returns you would have gotten when they’re 15:1. So some people think they’ll get very high returns in a stock market. That will not be true, guaranteed. You know, I’m not making a prediction for next week or next year, but for the next decade you will not get 7 percent real return, the historic average. No way on earth will we get that. I’ll say that, I feel very confident in that. We will not see that. The other point, of course, stock prices can fall. So people ask me, when we had those downturns, is this the correction, are we going to see prices fall 10 percent 20 percent? Those are real possibilities. I won’t rule that out.

What I do rule out, what I do say is not the case, is we don’t have a bubble like we did in the late ’90s. And why I’m saying that, one, stock prices are not as high relative to earnings. But the other, and really more important point my book, is stock prices are not moving the economy the way they were in the late ’90s. In the late ’90s it’s easy to see stock prices were moving the economy both because there was a huge flood of investment, really in that case directly driven by stock prices, because companies actually were selling stock and using it to finance investment. That’s extraordinary. That was going on in the late ’90s. And the other was it was driving consumption. So you had people who saw their 401(k)s double in value, and they were going great, I don’t have to put any money in my 401(k), I’m going to take a big vacation. You were seeing that.

So it was driving consumption. A huge spur of investment. We do see some increase in consumption partly due to stock prices, I’m sure. High house prices, also. But nothing really on the investment side. So what that means to me is, let’s say we were to see the stock market fall 10, 15, 20, percent, not a prediction but certainly a plausible scenario. Some falloff in consumption, that will dampen growth. Little change in investment. Doesn’t give us a recession. Doesn’t give us a big downturn. So in that sense I don’t think we face the same sort of risk of a bubble that we did in the late ’90s.

SHARMINI PERIES: Now, let’s compare this to the Great Recession of 2007-2008. What were the conditions that were pending, that led to that, that doesn’t exist now?

DEAN BAKER: Well, there you also huge run up in house prices we have seen house prices come back but not like they did. They aren’t as high adjusted for inflation as they were in 2006-2007. But the other really important point about that is in this case house prices are moving more or less in step with rent. So we’ve seen rents going up a huge amount in the last five, six, seven years. Not necessarily the same amount as house prices, but they are definitely outpacing the overall rate of inflation, which indicates there is real tightness in the housing market with a very low vacancy rate. That wasn’t true in 2006-2007. Vacancy rates were already at record highs. So in that case it was easy to see it as a speculative bubble. Here, it’s clearly being driven by a tight housing market.

Now, I’ll qualify that a little bit. One of the things I find very disturbing is that the biggest runup in house prices has been at the bottom end of the market. This is particularly true in places like Miami, like Los Angeles. What I worry about there, it’s not a macro story. Let’s say the bottom end of those markets and a few others fell by 15, 20, percent, 25 percent. That’s not going to sink the economy as it did back in 2007-2008, but it will be very bad news for a lot of moderate income people that put all their savings into buying a house. And that’s of course what happened with the subprime borrowers back during the housing bubble years. So I worry that some of the same people may get hit again.

It’s not, it’s not a great recession story. Probably not even a recession story. But it is very bad news for a lot of people who were struggling and thought buying a house is a great investment if it turns out that price subsequently plummets.

SHARMINI PERIES: Finally, Dean, with the recent appointment of Jelena McWilliams as the head of the FDIC some say that Trump finally has got his deregulatory team in place at the FDIC, as well as Treasury and the currency regulatory body. If this team, and of course Senate and House, approves the withdrawal of the 2010 Dodd-Frank regulation that has already passed the Senate and might pass the House as well, does this kind of deregulatory environment affect the price of things in the market, and therefore contribute to bubbles?

DEAN BAKER: Not necessarily. You know, as I mentioned before, the bottom end of the market, I’ve not heard the same sort of abuses that you had during the subprime years. Which doesn’t mean they’re not happening, but certainly not on the same scale. What I worry primarily about with the deregulation is that you’re licensing financial institutions to rip people off. And just take it for granted, financial institutions are there to make money. And if they can make money by providing better services to their customers, that’s what they’ll do. If they can make money by writing deceptive contracts and finding ways to rip people off, that’s what they’re going to do. And basically, the Trump administration, the Republican Congress, seem determined to give financial institutions a green light to rip people off as much as possible, in which case we should expect that they’ll rip people off as much as possible, and that’s not a good business model.

SHARMINI PERIES: All right, Dean. I thank you so much for joining us today.

DEAN BAKER: Thanks for having me on.

SHARMINI PERIES: Thanks for joining us here on the Real News Network.