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Booms
and Bubbles Revisited
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R.CHAND
Booms:
The business or economic cycle is the periodic but irregular
up-and-down movements in economic activity and other
macroeconomic variables. The cycle involves shifts over time
between periods of relatively rapid growth of output
(recovery and prosperity), alternating with periods of
relative stagnation or decline (contraction or recession).
These fluctuations are measured using the real gross
domestic product. Traditional
business cycles undergo four stages: expansion, boom,
contraction, and recession. After a recessionary phase, the
expansionary phase can start again. The phases of the
business cycle are characterized by changing employment,
industrial productivity, and interest rates. In the diagram
below, we also present the cycles in terms of deviations of
actual output from potential output
.
The
cyclical fluctuations or output gap can be caused by shocks
to aggregate demand and to aggregate supply. An aggregate
supply shock is a shock that alters the cost of producing
goods and services and, as a result, the prices that firms
charge. An aggregate demand shock is a shock that shifts the
demand for goods and services and, as a result, changes the
equilibrium prices. Measures of potential GDP were initially
devised to guide decisions about monetary and fiscal policy,
generally for a one- to two-year horizon. If the economy was
estimated to be below potential -- meaning that labour or
capital was not fully employed -- then monetary or fiscal
policy could be used to speed up the growth of output
without incurring the risk of significantly higher
inflation. The concept of potential output was seen as a
tool to help policymakers manage aggregate demand and thus
maintain steady economic growth. Thus, over the medium term,
the estimated trend in potential output helps determine the
pace of sustainable growth
Equipped
with these basic tenets of cycles, we can easily discard
such assertions that
(a) interventionist
government policies cannot affect or reverse the direction
of the cycle, (which is in contradiction with other
statements that “the itch… of the ruling majority to
control economic phenomena might inhibit growth”) and
that China cannot experience a future downturn;
(b)
as the economic cycle evolves towards the services industry,
the Mauritian economy will become less volatile, and
(c) economic disequilibrium is caused by lax monetary policy
and that equilibrium can be restored only by an inevitable
but necessary recession.
Moreover,
our understanding of the mechanism of the
economic cycle allows us, as depicted in Figure 2, to
question another controversial assertion that the
“Mauritian economic cycle is flat”.
One
of the oldest conjectures in economics holds that
self-fulfilling shifts in optimism or confidence can
destabilize aggregate economic activity. Change in
expectations for example cause the economy to cycle back and
forth between periods with high levels of investment and
rapid GDP growth and periods with low levels of investment
and slow GDP growth. Almost ten years ago a financial
typhoon ripped through East Asia, battering markets,
uprooting businesses and shattering lives, currencies and
political regimes. It also destroyed the myth of the
invincibility of Asia's "tiger" economies, (that
progress cannot be stopped,) which had until then
enjoyed decades of vigorous and uninterrupted growth. For
two generations the state in China, South Korea and Japan
intervened in the economy to funnel the financial resources
into favoured firms, mainly in heavy industry, and coddled
those companies through cartels and protectionism. The 1997
crisis laid bare the results of this system -- overcapacity,
wasted money, insolvent firms, troubled banks and lack of
funding for new, innovative firms. Cyclical fluctuations are
not the culmination of random influences of the invisible
hand. Both the pace and direction are determined by economic
policies and their timing (whether pro-or anti-cyclical).
It
seems quite simplistic to single out the lax monetary stance
as the precursor or the main indicator of an unavoidable
recession. Besides the parameters that we have stressed
above, there are other cyclical indicators that help to
define the business cycles. Leading indicators are series
that tend to shift direction in advance of the business
cycle whereas Coincident indicators are series that measure
aggregate economic activity and Lagging indicators tend to
change direction after the coincident series -- they are
used to confirm turning points and to warn of structural
imbalances that are developing within the economy. (Average
weekly hours, manufacturing, Building permits, new private
housing units, unit labour costs, capacity utilization,
etc.)
Bubbles:
Identifying a stock market crash is easy: “When you see
it, you know it” (Mishkin and White). However, it is more
difficult to “see” and “recognize a bubble than a
crash, even ex post.”
We have to be very careful in our affirmation of the
existence of a bubble on the basis of either flimsy or
limited data (like share of corporate profits or operating
surplus to GDP). A bubble reflects growing misalignments
from fundamental values. Detecting a bubble entails
asserting knowledge of the fundamental value of the assets
in question. Bubbles are attributable to: passive
accommodation of booms by the banking system or monetary
policy; poorly designed monetary policy --e.g., interest
rate policy without commitments to a steady long-run
inflation rate; misplaced expectations: e.g., investors’
overconfidence; micro factors: Information asymmetry and
short-sale constraints -- e.g., stock prices can rise above
their fundamental value with dispersion of investor belief.
A
simple and widely used yardstick is the historical evolution
of price-earnings (P/E) ratios. A P/E ratio of 15, which
entails an earnings yield of close to 7 percent a year,
which we may gauge as fair or near equilibrium stock value.
But we may wish to support it with the Gordon valuation
formula to calculate equity risk premium by averaging the
P/E ratio, the dividend yield (D/P), real GDP growth (which
can be thought of as a proxy measure of the expected growth
of real earnings), the interest rate, and the inflation
rate. If historical risk premium > implied risk premium,
it may indicate the existence of a bubble. We can also use
trend analysis to compare the moving averages of the stock
price index, output, productivity, and credit or monetary
aggregates or by interpreting financial imbalances through
the credit gap as measured by deviations of credit growth
from trend. Persistent deviations from the long-run
relationship are associated with the risk of bubbles.
Measures:
We have also to be as careful in our suggestions for
pricking the bubble. A bubble is dangerous to prick, since
there is a risk of creating further financial instability.
Alan Greenspan (Economist, Sept. 7-23, 2002,) took a
quite conservative stance on this: “Central banks
cannot use interest rates to prick bubbles in their early
stages because they can never be sure if there is a bubble
or not. Moreover, a rise in rates sufficient to prick a
bubble could push the economy into recession.” Some of
proactive responses that have been suggested to asset price
bubbles, helpful for macroeconomic stability, are:
monetary policy should respond to -- but not target
-- movements in asset prices; monetary policy tightening is
optimal in response to “irrational exuberance” in
financial markets and higher interest rates could be
accompanied by an explicit commitment to fight bubbles. At
the micro-level, the proposed financial policies to reduce
bubble incidents and enhance economy’s resiliency to
shocks are effective regulatory frameworks and good
financial structures, including healthy balance sheets.
Monetary
policy reactions to movements in asset prices are
complicated and may exacerbate the problem because of the
difficulties in identifying bubbles in advance, the lags in
monetary policy effects and the expectations of future
policy settings. To conclude I’ll add that that monetary
ease is neither necessary nor sufficient to produce bubbles.
Bubbles are made in financial markets, not in central banks.
If an economy is likely to grow at the rate below its
potential and inflation expectations are low and stable,
there is no economic justification for thinking that a
simulative monetary policy somehow creates a growing debt
that has to be made up later. In my next article, I’ll
address the issue of the sustainability of the forecasted
Mauritian boom.
R.CHAND
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