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Here is one typical complaint about bubbles, from Jesse Eisinger, excerpt:

We are four years into the One Percent’s recovery. Now, we are in Round 3 of quantitative easing, the formal term for the Fed injecting hundreds of billions of dollars into the economy by purchasing longer-term assets like Treasury bonds and Fannie Mae and Freddie Mac paper. What’s that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields at record lows. Ratings shopping on structured financial products.

These are dangerous signs of prebubble activity.

Here is a Krugman rebuttal.  I will offer a few points on a series of debates which in general I have stayed away from.

1. I don’t find most predictive discussions of bubbles interesting, while admitting that such claims often will prove in a manner correct ex post.  “OK, the price fell, but was it a bubble?  I mean was there froth, like on your Frappucino?”  Or to quote Eisinger, it might also have been “dangerous signs of prebubble activity” (what happens between the “prebubble” and the “bubble”?  The “nascent bubble”?  The “midbubble”?  The “midnonbubble”?)

2. Good news and improving conditions may well bring more bubbles or greater likelihood of bubbles, but that is hardly reason to dislike good news and improving conditions.

3. Relative to measured real interest rates, stocks look cheap right now.  That doesn’t mean they are, but reread #1.

4. No one understands the term structure of interest rates, no matter what they tell you.  Reread #1.

5. I don’t see why anything particular about the current state of affairs, at least in the United States, needs to be “unwound.”  I sometimes draw a distinction between those of us who have been thinking about interest on reserves since S. Tsiang, Fischer Black, and the Reserve Bank of New Zealand, and those of us who have not.

6. One coherent definition of bubble is that of a hot potato, traded in a world of heterogeneous expectations, but which must ultimately pop, because eventually the price of that asset will consume all of gdp, a bit like those old Tokyo parking spots.  Fair enough, but I don’t see that in many asset markets today if any (Bitcoin for a while?).

7. Another coherent definition of a bubble has less to do with a dynamic price path and ongoing resale for gain, but rather there may be a (temporary) segmentation across classes of asset market buyers.  The obvious candidate here is that  many people and institutions have been frightened into Treasuries and away from almost everything else.  That could mean we have a real interest rate bubble, but it also could mean that lots of other assets are undervalued, at least if the liquidity effect defeats the higher real interest rate effect of moving out of Treasuries.  (It would be odd to think that a shift of funds out of Treasuries and into stocks would cause stock prices to fall, but perhaps some people fear this.)

I don’t agree with this view, but I do feel I understand it.  The most likely “bubble” is then in real interest rates, due to a (temporary?) skewing of the risk premium.  That all said, I do not think this should be called a bubble.  Changes in the risk premium and “bubbles” have traditionally been considered alternative explanations for asset prices.  Reread #1, and reread #4 while you’re at it.

8. Ruchir Sharma made some interesting points yesterday:

Far from fighting off a deluge of foreign capital, leaders from India to South Africa are struggling to attract a greater share of global capital flows in order to fund widening current account deficits. Over the past decade, the foreign exchange reserves of the developing world grew at an average annual rate of 25 per cent, swelling from $570bn in 2000 to $7tn in 2011. But over the past year, the average rate slowed to a crawl of barely 5 per cent.

The idea that money is still flooding emerging markets misses the big picture, which is that global cross-border capital flows are down 60 per cent from their 2008 peak. The largest shares of cross-border capital flows are in bank loans, trade and foreign direct investment, which are slowing worldwide.

9. I expect the real economy over the next twenty years to be more volatile than it was say in the 1990s.  In that sense, many current asset market prices may be revised and quite dramatically.  Still, I don’t find the bubble category to be so useful in this regard.  We really don’t know what is going to happen and that is why the current prices are wrong, not because of a “bubble.”

10. I am probably done blogging about bubbles for a while.  Satisfying you was not the goal of this post, but that is in the nature of the subject area, not out of any desire for spite.

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In response to this post, Paul Krugman writes:

Suppose that I could wave a magic wand (or play a few notes on a a Magic Flute) and suddenly increase all German wages by 20 percent. What do you think would happen to the value of the euro against the dollar and other currencies? It would drop a lot, yes? And Portuguese exports would become a lot more competitive everywhere, including non-German and indeed non-Euro destinations.

I guess I thought this was obvious. Apparently not.

Let’s start with the data.  Portuguese exports have indeed gone up since 2009, with the weaker euro likely being one reason.  Here is a recent positive report.  Still, this experience shows higher exports are unlikely to prove their salvation.  Last year Portuguese shipments outside Europe rose by twenty percent, but that is from a fairly small base.  The country continues to have high unemployment and falling gdp, doing worse than does Ireland on the test which Krugman repeatedly applies to Irish recovery.  The Portuguese forecast for this year is 2.3% gdp shrinkage and 18% unemployment, and that is with an export performance described as “surging.“  “Surging” isn’t enough.

[A digression: If you are tempted to argue that "exports arising from inflation in Portugal would be so much more potent than the export boost from the status quo," keep in mind that we are dealing here with the postulated scenario, accepted by Krugman for the sake of argument, where the euro falls, stimulating exports, as indeed has happened, but the inflation stays in Germany and does not spread to Portugal.]

To dig deeper, we might ask how strong the additional export elasticity, with respect to euro devaluation, is going to be.  The leading export partners of Portugal are Spain, Germany, France and Italy, not a surprise.  So a weaker euro won’t much help them on those fronts.  Around 71% of their exports go to the EU and most of that will be to the eurozone.  Next in line is the UK but the pound has fallen too and according to many should (will?) fall even further.  The BRICS are ailing on the growth front.  Team USA is not going to turn Portugal around, we just don’t buy enough cork.

The main import of Portugal from outside the eurozone seems to be petroleum, so a weaker euro hurts them on that front.

Portugal is also a victim of what is called “the gravity equation,” namely that distance hurts the prospects for trade and in a manner which is strongly non-linear.  Think about the map or failing that read Saramago’s The Stone Raft — Portugal is close to other eurozone countries and to some (relatively poor) parts of Africa, otherwise it is pretty far from most places.

As an aside, it is strange for Krugman of all people to so stress the real exchange elasticity of exports.  To do a bit of history of economic thought (pdf):

In particular, the seminal paper by Baldwin and Krugman (1989) shows that the existence of a sunk entry cost into the export market generates a persistent effect of real exchange rate movements on bilateral exports. The model also suggests that a larger sunk entry cost generates a more persistent effect, or equivalently a lower reaction of exports to real exchange rate movements [emphasis added]. We specifically test this theoretical prediction by making use of various measures of trade costs that can be associated to the sunk entry cost.

In other words, real exchange rate movements are not a panacea, and furthermore this is all the more true for countries which are in a disadvantageous position due to…the gravity equation.  The higher export elasticity for Portugal may well be through the dreaded internal devaluation, because that is at least relative to their close and most likely trade partners.

Krugman’s own words on the topic were “huge swings in the exchange rate have had only muted effects on anything real,” to cite one claim out of numerous similar passages.

[Now that sentence is from 1989 and perhaps now you will leap up and accuse me of not allowing Krugman to change his mind, or of thinking he wanted to raise marginal tax rates in 1959, or of seeing 1978 as a liquidity trap.  Please.  This is a fairly general result, but, if the relevant elasticities have indeed gone up significantly since 1989, and indeed that is possible, that is worth discussing.  But rather than making a case for such a change, Krugman's response of "Portuguese exports would become a lot more competitive everywhere, including non-German and indeed non-Euro destinations.  I guess I thought this was obvious. Apparently not." is little more than a self-parody of his own style of argumentation.]

In sum

We can all agree that inflation centered in Germany has some positive spillover effects to Portugal.  But let’s go back to the initial question, a positive rather than normative one.  Can a German prime minister credibly promise that significantly higher inflation would set things straight in the eurozone periphery or for that matter fix Portugal?  I don’t think so, though it may have worked in 2009, as indeed I argued at that time.

Krugman amended his initial post to state the following:

Again, as Ryan [Avent] says, the crucial difference between German/ Portuguese economic relations and, say, US/ El Salvador (whoops: some central American countries have dollarized. But that was their choice, not part of a grand project like the euro) relations is that Germany and Portugal share a currency. This creates obligations for Germany, whether it likes them or not.

That’s a good example of “distraction by introducing or stressing a moral issue.”  (You can track some of Ryan’s related tweets here.)  One can indeed argue the extent of Germany’s moral obligation to its fellow parties in a “we’re all in this together but no bailouts and price stability” treaty.  But the issue on the table was how much more inflation would help Portugal and other nations of the periphery; surely an understanding of that question should come first.

If someone argues “it may not help as much as you think at this point,” and the response is “Germany must be morally (and financially) committed to the grand project,” that is an object lesson in precisely why Germany and some other nations are insisting on so many limits and rules within the eurozone and EU.  Krugman is fond of saying he wants to change the world and not just engage in polite dinner table conversation, but may I suggest his framing is not likely to prove an advance marketing beachhead for the ideas of fiscal union and banking union in Berlin much less Helsinki or for that matter Paris?

As for myself, when the Krugman/Avent case for the German moral obligation so frequently and so quickly jumps to what Daniel Klein has called “The People’s Romance (pdf),” and so infrequently gets into the nitty-gritty of the positive economic argument, that makes me nervous too.

There is the usual snark in Krugman’s post, but if you read it through you will notice it does not cite a single fact or estimate.

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