The next set of asset bubbles...

Kenneth Rogoff, Harvard professor and co-author with Carmen Reinhart of "This Time is Different: Eight Centuries of Financial Crises" should know something about price bubbles. He discussed the prospects of new bubbles forming in an article published in the Financial Times:

As the global economy reflates, many people are asking: “Is the next bubble in gold? Is it in Chinese real estate? Emerging market stocks? Or something else?” A short answer is “no, yes, no, government debt”.

We find that debt-fuelled real estate price explosions are a frequent precursor to financial crises. A prolonged explosion of government debt is, in turn, an exceedingly common characteristic of the aftermath of crises. But a deeper question is whether economists really have any handle on ferreting out dangerous price bubbles. There is much literature devoted to asking whether price bubbles are possible in theory. I should know, I contributed to it early in my career.

In the classic bubble, an asset (say, a house) can have a price far above its “fundamentals” (say, the present value of imputed rents) as long as it is expected to rise even higher in the future. But as prices soar ever higher above fundamentals, investors have to expect they will rise at ever faster rates to make sense of ever crazier prices. In theory, “rational” investors should realise that no matter how many suckers are born every minute, it will be game over when house prices exceed world income. Working backwards from the inevitable collapse, investors should realise that the chain of expectations driving the bubble is illogical and therefore it can never happen. But then along came some rather clever theorists who noticed that bubbles might still be possible (in theory), if we lived in a world where the long-run risk-adjusted real rate of interest is less than the trend growth rate of the economy.

The real issue is not whether conventional economic theory can rationalise bubbles. The real challenge for investors and policymakers is to detect large, systemically dangerous departures from economic fundamentals that pose threats to economic stability beyond mere price volatility.

The answer is to look particularly for situations with large rapid surges in leverage and asset prices, surges that can suddenly implode if confidence fades. When equity bubbles burst, investors who made money in the boom typically swallow their losses and the world trudges on, for example after the bursting of the technology bubble in 2001. But when debt markets collapse, there inevitably follows a long, drawn-out conversation about who should bear the losses. Unfortunately, all too often the size of debts, especially government debts, is hidden from investors until it comes jumping out of the woodwork after a crisis.

In China today, the real problem is that no one seems to have very good data on how debt is distributed, much less an understanding of the web of implicit and explicit guarantees underlying it. But this is hardly a problem unique to China.

The timing is very difficult to call, as always, but even as global markets continue to trend up, it is not so hard to guess where bubbles might be lurking.