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Forever Blowing Bubbles

It's looking like we have moved from the crash to the bubble and skipped the economic recovery.

April 17: This post has been clarified.

Are we moving from the crash to the bubble, dispensing with that pesky economic recovery thing altogether?

The Federal Reserve is well into its third round of "quantitative easing," in which it buys longer-term assets to bring down long-term lending rates. We are about five and a half years into the Fed's extraordinary monetary policies (its out-of-the-box lending programs began before the crash, in late 2007).

The effect the central bank hopes to produce hasn't materialized. Despite modest growth, the economy remains a wellspring of misery, with mass unemployment, wage stagnation and factories going unused. In March, a smaller percentage of working-age people were actually working than at any other time since 1979.

Through its unconventional policies, the Fed is trying to alleviate the crisis. It has succeeded in driving down lending rates. Ben S. Bernanke and company would also like to kindle inflation expectations, spurring people to buy and companies to invest today instead of waiting until tomorrow. Supposedly, all of this will drive a self-sustaining economic recovery.

Instead, the Fed has kindled speculation. Investors are desperate for yield and are paying up for riskier assets. In areas like real estate, structured finance and equities, the markets are ahead of the fundamentals. It doesn't look to me like a bubble yet. But I would call it the Dysplasia Stage, abnormal growth that looks precancerous.

It's not just an economic or financial issue, it's cultural and psychological. We seem to have unlearned what real growth is and simply substituted speculative bubbles. Policy makers are either paralyzed or barrel forward because this is all they know how to do.

Let's first take the stock market. On the standard measures of looking at estimated earnings, the Standard & Poor's 500-stock index isn't particularly high. But that's misleading. Corporate earnings are extremely high as a percentage of the gross domestic product. Margins are high. Is that sustainable?

There are more reliable measures of stock market value, and they look frothy. One gauge, the price of stocks based on the past decade of earnings, is named after the Yale economist Robert J. Shiller. Using that, stocks are too expensive by 65 percent. Alternatively, many investors look at something called the Q, devised by the economist James Tobin, which compares stock prices with corporate net worth. The nonfinancial companies are overpriced by 57 percent. The stock market is not at 1999 or 1929 levels, but it has reached other previous peaks of 1906, 1936 and 1968, according to Smithers & Company, a London-based research shop.

To make stocks correctly priced, "either earnings have to explode heavensward for 10 years or else stock prices have to come in a lot," said Scott Frew, who runs Rockingham Capital Partners, a small hedge fund. He expects earnings to fall.

It's not just stocks. Investors are bidding up junk bonds, commercial mortgage-backed securities and bundles of corporate loans called collateralized loan obligations. Last month, investors were paying more for such loans than at any time in the last five years. They are snapping up billions of dollars in securities made up of subprime auto loans.

And the housing market isn't just rising, but roaring back so fast you can feel the G-force coming off the reports. Home prices in Phoenix went up 23 percent over the last year, according to the latest Standard & Poor's Case-Shiller index. More than one in four homes in Phoenix were purchased by investors who bought more than five homes apiece, up from 16 percent a year earlier.

"I am now starting to become less skeptical" about the worries over a new housing bubble, said Christopher J. Mayer, a real estate economist at Columbia University. When local money is on the sidelines and outside buyers come in to snap up real estate, that typically ends badly, he added.

So what's going on?

The Fed is engaged in "trickle-down monetary policy," said Daniel Alpert, managing partner of Westwood Capital, an investment bank. "This type of monetary policy is making the wealthy wealthier and hoping that it trickles down to the shop floor."

But "trickle down has never worked," he said. "The wealthy don't need to consume. And when there is oversupply of capacity, the wealthy don't need to invest in new capacity."

Has the Federal Reserve monetary policy reached the average American? To a certain degree, yes. Many Americans have been able to refinance their homes. Those auto loans may be helping people get to and from work.

But the economic effects are modest for the size and scope of the effort. Investors, meanwhile, glory in the asset inflation. The most pronounced effect of low mortgage rates has been to allow people with good credit and low debt to refinance multiple times over the last few years. Stock ownership is concentrated among the wealthy; junk bonds and collateralized loan obligations only more so.

Alpert says the first round of quantitative easing was necessary to alleviate the liquidity problem in the markets — the unwillingness of investors to conquer their fears and buy up assets. But the third round is "unnecessary," he said.

Others disagree. Dean Baker, an economist from the liberal-leaning Center for Economic and Policy Research who warned about the housing bubble much earlier than most, doesn't see a bubble yet. He advocates continuing quantitative easing.

Baker adds a note of caution, however. Regulators should move to high alert; Federal Reserve officials should start speaking out to signal that they are paying attention to the abnormalities. Eric S. Rosengren, the president of the Federal Reserve Bank of Boston, gave a recent speech raising areas of concern, only to dismiss them as not overly worrisome yet.

At least he was thinking about the issue. As with cancer, the key is to intervene early.

Clarification: A quote from real estate columnist Christopher J. Mayer has been clarified to read that he has "become less skeptical" about the worries over a new housing bubble, not less skeptical that we are moving toward a new housing bubble.

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