Tight Money Causes Bubbles

Of course I should have said “is associated with,” not “causes.”  But if you are trying to be provocative, why stop halfway?

I’d rather not talk about bubbles at all.  I find them boring, misleading, and I don’t “believe in them.”  (I don’t disbelieve in them either.)  But my commenters force me to continue talking about them.  So here is something designed to enrage everyone.

The Fed was created in 1913.  Let’s throw out the decades when there were World Wars, which (according to Krugman) were hopelessly distorted by rationing and price controls.  Here I will divide up decades into those with easy money (indicated by high and/or rising inflation) and tight money.

Easy money: 1960s, 1970s

Tight money: 1920s, 1930s, 1950s, 1980s, 1990s, 2000s.

Yes, I know the 1980s had more inflation than the 1960s.  But the rate trended sharply lower in the 1980s, and most economists think that is what really matters in terms of the real effects of inflation.

Now let’s look at bubbles of major significance.  This is subjective, but I will exclude bubbles that apply to individual stocks, commodities, or local real estate markets.  I want bubbles of macro significance.  I will also list the bubble peak, and whether there seems to be a rational explanation.  Note, according to some definitions of ‘bubble,’ if there is a rational explanation that is consistent with economic theory, it isn’t really a bubble.  But I am not interested in debating that issue here, I just want price spikes generally regarded as bubbles:

September 1929, stocks, fundamental explanation

Mid-1937, stocks and commodities, fundamental explanation

August 1987, stocks, deeply mysterious

April 2000, stocks, partly explicable, partly mysterious

Early 2006, housing, fairly mysterious (especially Vegas and Phoenix)

Early 2008, commercial real estate, fundamental explanation

Mid-2008, commodities, fundamental explanation

What do you notice about the pattern?  None of the 7 bubbles occurred in the easy money decades of the 1960s and the 1970s.  Why then this almost universal belief that easy money causes bubbles?

1.  People often misinterpret the stance of monetary policy.  As Milton Friedman observed, low interest rates are not easy money, they are a sign that money has been tight.  Tight money can depress rates in two ways, the Fisher effect and the income effect.  Thus tight money can lower inflation and real growth, and both of these effects tend to reduce nominal rates.

2.  People confuse easy money and easy credit.  Easy credit can co-exist with tight money.  Easy credit may contribute to bubbles (I don’t have an intelligent opinion on this question.)

3.  More sophisticated observers will point to real rates.  But not all bubbles are associated with low real rates.  The best example is 1937, when rates were very low because the economy was still very depressed.  Another example is the two 2008 peaks, when real rates had fallen due to weakness in the economy.  In other cases observers blame low real rates during the formative stages of the boom (say 1927, or 2003), not at the peak.

Do I really believe that tight money causes bubbles?  Given that I don’t believe in bubbles; that would be kind of silly.  But I do believe that “bubbles” are just as likely to form during decades when inflation is low, or falling, as during decades when inflation is high or rising.  It’s something to think about.

PS.  Many readers may find my views on bubbles confusing.  Last March I explained why I don’t think the debate over the EMH is very interesting.  The question isn’t whether the EMH is “true” or not (social scientists don’t even agree on what “true” means.)  Rather the question is whether the EMH or the anti-EMH position is more useful.  I have found the EMH to be very useful, but I haven’t seen any uses at all for the anti-EMH position.  That is what I mean when I say I don’t believe in bubbles.  I do not mean that I think Fama’s models can explain any and all market fluctuations.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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