Bubbles….what are they and why can the Fed not see them?

In a previous post:

I commented on Janet Yellen’s putdown of suggestions of excess usually associated with the term “bubble” and graphically demonstrated that there existed a significant divergence between US economic/income growth and asset values (debt/equity) that would suggest a bubble of sizeable proportions existed. 

I also provided a link to a prior post on bubbles that mentioned per se that the very fact that asset values tended to discount the future, in a monetary system, meant that bubbles were in fact a de facto natural component of a monetary driven economic paradigm.  The key issue was the balance and the relationship between the two, itself a function of the nature and balance of fundamental economic relationships and their emergent properties.   A great many of my previous posts assert the existence of a perilous divergence and describes the many imbalances that have accentuated this imbalance and which have added to its instability.  

When we talk of bubbles in the same frame as bursting and collapse what we are talking about are unsustainable relationships that are being pushed to their extremes and beyond.   We are talking about divergence in the order of things, about structures whose natural relationships are being pushed so far out of alignment that minor shocks produce extreme outcomes..  This is where the statistician’s fat tail comes in and once we realise that we have an imbalance it is no longer a fat tail but a much higher probability outcome.

A bubble may burst in the sense that the growth of the energy in the system exceeds its structural ability to continue to expand at a rate consistent with the change in energy.   This could be seen as inflation in the economy or as inflation in an asset price as demand for that asset outstripped its value and the ability to supply that demand.  Bubbles in this context can lead to misallocation of resources as noted in a recent BIS report on this issue.  

A bubble can also deflate in the sense that the energy driving the fundamental drivers of growth in the system either no longer require the frame to expand at the same rate or, indeed, that the financial frame needs to scale backwards to accommodate the decline in system energy (this would be the case where demographics are slowing and are in decline and where productivity growth has slowed and also where distribution of income is impaired). 

If monetary and fiscal decision makers view the gear change in growth as a temporary aberration and attempt to force expansion of either/or both the fundamentals and the financial frame, when in fact the frame is naturally contracting (depreciating) or its growth rate slowing, then we risk divergence between the fundamental drivers of the system and the frame.  In other words the energy added to the system complicates the much needed adjustment of the  frame as stimulus temporarily expands both, and in the current case, expands the financial frame at a growth rate well in excess of the fundamentals whose own trajectory has been temporarily amended.

In other words where we have had slowing demographics, transitory economics and monetary stimulus as well as increasingly skewed distributions of national income.  We have had a de facto bubble developing and this has manifested itself in ever higher levels of debt and asset focussed money supply growth at the same time as productivity/demographic/CAPEX/economic/income growth have decelerated.  But either the Fed cannot see or, perhaps like many regulators, it does not feel that righting bubbles is its mandate.  All the same the extremely narrow focus on system dynamics is a disturbing one that has more than likely been a major vitiating factor in the development of current imbalances.

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