Guarding Against Asset Bubbles

The Economist last week had some interesting thoughts on what went wrong with economic thinking.  They mentioned that Central Banks around the world paid too much attention to maintaining low inflation, and too little attention to asset bubbles.  I agree.  Having observed several asset bubbles in the last two decades, I have seen in the type of distorting activity that occurs in bubbles is dramatic and, in my opinion, understated by economists.  During bubbles, the perceived future value of an asset increases beyond reason, and this causes consumers (people like you and me) to undertake unhealthy economic activity.  The primary focus of economists has been on the distortion of assets, spending too much and particularly leveraging too much into the asset bubble.  The leverage portion was particularly important for real estate, and the consequences are stark.  Now, its estimated that 1 in 5 homeowners owe more on their mortgage than their house is worth.

In addition to overbuying and over leveraging, bubbles are distortionary from an income perspective in that they divert funds away from areas that need capital.  In other words, good projects face a difficult time getting investors.  And one of the key issues that I rarely see discussed regarding asset bubbles is the shift in behavior of people due to the asset bubble.  During the dot-com boom, lots of people fancied themselves to be day-traders. Some even quit their regular jobs, that they had trained years for, to begin day-trading.  Needless to say, although the news focused on the one or two instances of success, I didn’t personally know anyone who got wealthy day-trading.  Then, the real estate bubble in the US ensued.  This one consumed a lot of people, all swearing that, “this time is different” and “they ain’t makin’ more land” and all of the characteristics signs of bubble thinking.  When I saw dentists, architechts, and engineers signing up for real estate licenses, it was a clear signal that this was an extremely frothy bubble.

So, given that Central Banks, policy makers and others tend not to focus on asset bubbles, it seems appropriate to try to look for the next bubbles forming, the areas where things seem to be mispriced, where double digit inflation rates in prices have gone on for years, and where capital is irrationally being funneled at the expense of other things.  And where behavior is being distorted.  Here’s my top 2 for bubbles to look out for:

College education — while I obviously believe in higher education, I have to wonder what will happen to people going tens, even hundreds of thousands of dollars into debt to obtain a degree.  At some point, it will basically be impossible to pay back the funds over a working lifetime.  In fact, for some graduates, I think that point was crossed a few years back.

Housing and real estate – while the housing bubble has deflated substanatially, most people are still putting too much of their net worth into housing and not enough into other investments.  The problem with owning too much house is that it doesn’t generate income, particularly retirement income.  I am astonished at the low average balances the typical household has for retirement.

As for bubble 3, I couldn’t decide between certain themes of green energy, health insurance, or commercialized blogging.  Not that there isn’t substantial merit in all 3 areas, just that the hype and current pricing seems to be exceeding the economic reality.

Posted at this week’s Carnival of Personal Finance