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Bubbles Abound In a World of Ready Cash

The house market is so hot, there is even the equivalent of day traders. Makin reports that during his drive in from the Key West airport recently, all the driver would talk about was the million-dollar condos that were flipped several times before construction was even completed. Five years ago, the talk was all about Nasdaq.

David Berson, the chief economist at Fannie Mae, takes note of the sharp increase in the number of homes being purchased solely for investment purposes -- up to 30 percent in some markets, by his reckoning. One study by the National Association of Realtors estimated that 23 percent of homes in 2004 were purchased primarily for investment.

Rising oil prices are reflected in the retail price of gasoline. Oil money feeds a growing global surfeit of cash. (Ted S. Warren -- AP)

_____Live Discussion_____
Transcript: Steven was online to discuss this column.
_____Past Columns_____
Ballpark Finance Requires Clear Thinking (The Washington Post, Mar 16, 2005)
Lapsed Lawyers Find a Good Fit With Finance (The Washington Post, Mar 11, 2005)
Ethics Pedestal Assures Some Hard Falls (The Washington Post, Mar 9, 2005)
Column Archive

The downtown office-building market is also red hot, despite the fact that, nationally, there has been little increase in net rents. Torto said most of the price escalation can be explained only by an expectation that price appreciation will continue at its current pace.

Phil Verleger, the energy expert, brings a similar analysis to the recent run-up in oil prices, which he said is being driven less by fundamentals (supply, demand and the cost of replacing reserves) than it is by the upward pull of futures markets. He said OPEC and its silent partners, the major oil companies, know that they earn the highest profit when oil inventories are lean, and the best way to keep them lean is to keep spot prices higher than futures prices. Now that every hedge fund and college endowment is in the futures market placing bets on higher prices over the next year, spot prices are following suit.

The current bond-market bubble was attested to by no less an authority than Greenspan, when he admitted he was puzzled by long-term interest rates that have failed to respond to the 1.75-percentage-point increase in short rates engineered by the Fed. Greenspan called it a "conundrum." I call it a speculative market driven by irrational exuberance and herd behavior.

A similar story is told by narrowing "spreads" on riskier bonds -- the interest-rate premium that borrowers have to pay over "risk-free" U.S. Treasury bonds. On the junk-bond market, spreads are near historic lows, with many new issues oversubscribed. In the market for emerging-market bonds, spreads that peaked at more than 10 percentage points at the time of the Argentine debt crisis in late 2001 fell to a low of 3.3 percentage points earlier this month.

It is more of a stretch to argue that stock prices have again entered bubble territory. Certainly as a multiple of earnings, today's prices are only slightly above historic averages. But there is a strong sense of deja vu in seeing banks and Wall Street investment houses tripping over one another to provide gobs of money on easy terms to companies and private equity funds engaged in bidding wars for telecom and software firms. And I assign some significance to the fact that Warren Buffett, who correctly identified the last bubble, now has $43 billion sitting in the bank, unable to find acquisitions to make at reasonable prices.

The tendency among economists has been to assume that bubbles happen only when there is too much cheap money around and that responsibility for controlling the money supply and containing bubbles rests with the Fed and other central banks. Adam Posen of the Institute of International Economics did a nice job of knocking down such outdated monetarism in a short, pithy article in a German newspaper last week.

But Posen -- like the Greenspan Fed -- also makes a mistake in concluding from that observation that policymakers need not worry about asset bubbles, largely because they have little long-run impact on what economists call "the real economy." That may once have been true. But this is a world in which billions of dollars earned by Chinese exporters can be recycled into Fannie Mae bonds, lowering U.S. mortgage rates enough to give a couple in Rockville the wherewithal to spend an extra $50,000 for their dream house. It's also a world in which billions of extra petrodollars now quickly make their way into hedge funds and real estate investment trusts that are bidding up the prices of satellite companies, Manhattan real estate and Treasury bonds. In such a world, the old distinctions between financial markets and the "real economy" quickly blur.

I don't know whether this means the Fed was right or wrong this week in not raising interest rates more than a quarter of a point and in sticking to its promise of "measured" increases in the future. What I do know, however, is that it is silly for the Fed to continue to ignore the condition of asset and currency markets when making such decisions and explaining them to the public.

Steve Pearlstein will lead an online discussion at 11 a.m. tomorrow at washingtonpost.com. Pearlstein can be reached at pearlsteins@washpost.com.

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