Wednesday, March 26, 2008

Asset Prices as the Driver of Business Cycles

Leo Tolostoy said "Happy families are all alike; every unhappy family is unhappy in its own way". Applied to financial markets, this would read as "all boom times are alike, but recessions are unique in their own way." It is at times like today which determine who is really a good investor and who is not.

Coming to recessions, the most often cited logic for business cycles is inventory mismatch. Greenspan viewed the 2000-01 bust as caused by excess inventory in tech sector, and will no doubt view today's bust as caused by housing inventory. But shouldn't one move one step back to what caused this inventory. That will be rampant speculation in asset prices - in tech in 2000 and in housing in 2007.

Conventional inventory buildups in the supply chain have become more manageable with the advent of technology and spread of supply chain management solutions. So, as the volatility of inventory has reduced, the big factor impacting business cycles might no longer be inventory, but something else.

Are asset prices the real driver of the business cycle now? In other words, do stock market and real estate market drive underlying economic growth, rather than the other way around? If that is the case, then the mandate of the Fed to promote substainable growth (i.e. reduce volatility of the business cycle) should force it to target asset prices. But they do not. They say thay if we were to target asset prices, then we would get an economic contraction, which is what we are trying to avoid in the first place.

I have enormous respect for Greenspan, despite him being regarded as the chief culprit behind the housing mess. He is right when he says that there has been a housing boom worldwide and not just in the US. So what exactly is the theory which made him reluctant to target asset prices?

Is it that bubbles are actually good? They are the best form of socialism. Somebody overinvests, and somebody else benefits. India benefitted from reduced telecom costs following the tech burst. If house prices fall a lot, many people who couldn't afford them earlier during pre-housing bubble times could afford them once the credit markets stabilize, as their incomes would have risen this decade.

1 comment:


The post is right on about asset prices.