Does Ben Bernanke blow bubbles too?

Submitted by Edward Harrison of Credit Writedowns.

During Alan Greenspan’s tenure at the helm of the Federal Reserve, he was often accused of using monetary policy to target asset markets so as to keep the party going. In short, Alan Greenspan was seen by many, including myself, as the bubble blower-in-chief. All of this came to an end with the very hard landing we have experienced after the global housing bubble.

However, despite the economy being in tatters and debt deflation looming as a threat, many asset markets have zoomed ahead. The cause: easy money in the U.S. and elsewhere. In the U.S., we have zero percent rates with Ben Bernanke at the helm. So, naturally, you should ask yourself: Does Ben Bernanke blow bubbles too?

To get at an answer to that question, I want to highlight a recent post on MoneyWeek called “The next big investment bubble – green energy.” In this article, research from James Montier of SocGen about investor attitudes in bubbles is quite enlightening.

James Montier at Societe Generale is a specialist in ‘behavioural finance’. This basically takes psychology and applies it to the field of investment and economics.

As someone who’s studied psychology in the past, I’d be the first to admit that it’s a pretty ‘soft’ science compared to something like physics, for example. But compared to the pseudo-science that is economics, it’s positively respectable.

And given that markets are anything but rational (even the Chartered Financial Analyst Society of the UK admits that a majority of its members have lost faith in the ‘efficient markets hypothesis’), it makes a lot of sense to take investors’ all-too-human characteristics into account when trying to figure out what markets might do next.

In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you’d think that investors would learn. If they’d seen one bubble, they’d be more careful in future.

And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.

In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, “far from learning from their experience in the first round, participants generally go on to create yet another bubble!” And when they were asked why, “the most common response was they thought they could get out before the top this time!”

However, when Smith asked the same players to play a third time, this time they’d learned. “You end up with a much tighter correlation between the market price and fundamental value,” says Montier.

So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.

…but they can get sucked into creating them

But that’s not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How? He cut the amount of stock available in half, and doubled the amount of cash in the game, “effectively creating what might be termed a massive liquidity surge.” This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.

“A massive liquidity surge” is exactly what the world’s central banks are trying to create just now. Montier says he has no idea if it will be large enough to “reignite a bubble (and of course another crash afterwards).” But as US fund manager Jeremy Grantham of GMO has pointed out previously, we’re currently seeing “the greatest monetary and fiscal stimulus by far in US history”. So if that doesn’t do it, arguably nothing will.

What does that tell you? It tells me that while many are chastened, the recent surge of liquidity is likely to result in bubbles nevertheless. The article looks to ‘green energy’ as a likely bubble market. But in “The next bubble” FT Alphaville look to a more conspicuous place, emerging markets. This article is definitely worth reading.

I would also point to the recent 40% surge in U.S. equity prices as evidence that liquidity factors are at play and that a bubble mentality is returning. Moreover, $70 oil in a period of depressed demand for oil doesn’t speak to a market running only on fundamentals. If oil prices are $70 today, they most certainly can and will rise to $100, $150 and beyond if recovery takes hold and demand returns.

Therefore, in my view, Ben Bernanke does blow bubbles too.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. WRM

    "Therefore, in my view, Ben Bernanke does blow bubbles too."
    Based on Big Ben's performance to date, I think a more correct statement is possible if you drop the last two words.

  2. One Salient Oversight

    Bernanke was a member of the Fed Board that worked with Greenspan to keep real interest rates negative between 2003 and 2005 (and which thus created the housing bubble).

    So he is therefore partly responsible for the mess we are in.

  3. Bill

    This is only tangentially relevant to this post, but I want to point out that I've been unsuccessful finding mention of the reasons for Bernanke's testimony today.

    CNBC is calling it "political games" that the Chairman of the Federal Reserve is being accused of a major coverup in witholding financially significant information from regulatory bodies during negotiations for the BAC acquisition of ML.

    I must say CNBC proves its worthlessness as a source of real news every day.

  4. Bill

    my apologies, for clarity my post above should read :
    "I've been unable to find mention in any mainstream media the reasons for Bernanke's testimony today".

  5. Bill

    OK, now they have a piece posted on CNBC, that smears both Congresspeople running the Bernanke hearing today.

    Yesterday, Issa was grilled by Liesman and Erin Burnett (would that they grilled all their banker and analyst guests in that manner), and they ended with an almost threatening tone, saying "Needless to say, we'll be following this story very closely"………….

    I guess this is what they mean. Posted only after the hearing has begun, with 35 year old "facts" aimed at discrediting both the leading R and D Reps.

    At least, CNBC in this case, is a bipartisan reptile.

  6. Sivaram Velauthapillai

    I have to disagree with the notion that these are bubbles (but admittedly it depends on what one considers a bubble.) A market rallying 30% to 40% off a major crash is not a bubble. It happens all the time. Just check 1930, 1932, 1933, 1975, 1991, and so on.

    For instance, if emerging markets (EM) rally 40%, they are not necessarily entering a bubble. EM would still be nowhere near the peak a few years ago. If EM is entering a bubble then what was it in 2007? And if you assume EM was in a bubble a few years ago, what are the chances it will go into another bubble within 5 years? It's very rare to see the same assets or sectors enter a second bubble.

  7. Sivaram Velauthapillai

    Edward Harrison: " If oil prices are $70 today, they most certainly can and will rise to $100, $150 and beyond if recovery takes hold and demand returns."

    You may be right but one has to keep in mind that investors are forward-looking. Oil maybe at $70 not just because of what happens today but because of future expectation. It is possible that growth in the latter part of the year and next year is already priced into oil. It's hard to say for sure but it wouldn't surprise me if oil goes nowhere near $150 (in current dollars) even if we get growth in the future.

  8. Alex

    Just a random pondering here about bubbles and inflation.

    The evils of traditional CPI inflation and the economic inefficiencies and dislocations that result are well-established.

    With the "slaying" of price inflation, we've instead had 20 odd years of asset price inflation that has still resulted in a substantial amount of economic dislocation (i.e. FIRE sector crowding out everything else, instability)

    So my thought is — between asset and CPI inflation, which is worse? Are we better off with nagging 8-9% inflation and homes that are not 10x avg incomes?

    More importantly, can a capitalist system even exist without some type of inflation to allow the unproductive and well-connected to profit?

  9. Richard Kline

    By far the greatest likelihood following a massive liquidity surge is a subsequent crash. There may be a bubble between the two. Or malinvestment. Or simple accounting games and embezzelment on a stupendous scale But just consider the context, and you'll see the endgame.

    Because the economy is flattened, there are few legitimate places for major _new investment_: there's no profit opportunities of note. At the same time, the authorities pushing said liquidity are exercising the opposite of stewardship over the massive funds and guarantees provided with very few constraints. Really no constraints. And it's "won't ask, don't tell" from the powers that be to the recipients of historically unprecedented, fully liquid, government guaranteed funds. Because those powers that be are in a fear funk over deflation and the political repercussions of high unemployment, so they're pushing money out by the palletful full of hope. Thus given much dough is available on incredibly easy terms but few opportunities exist for legitimate profit, we are left with three options: a) speculation, b) pecculation, c) sloth. C) is unlikely; a) and b) near certain.

    When all that money in motion ends up yielding no profit, or little enough, there will be a point there the jig, as they say, is up. New crash to follow. Or more perhaps faceplant on the jagged bottom of the economic cycle.

    To me, the plan pursued by US officials is madness. There are good short term reasons to guarantee liquidity backstops and use massive stimulus in a crisis of the kind we have. If one has the financial system by the scruff to the money actually goes to work and is deployed with some shred of wisdom. Those latter conditions are not in effect; are deliberately _prevented_ from being in effect or coming into effect by those at the top of the present Administration.

    By that line of thinking, then, those running the government have the means to know that a secondary crash is highly likely from their behavior. If they are deluded about this, or in connivance, we need not be. ( :

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