This Expansion Will End in a Fizzle, Not a Bang

Concern about a collapse in asset prices will lead the Fed down the path of excessive tightening.

Equity prices are “somewhat rich.”

Photographer: Andrew Harrer/Bloomberg

The Fed is growing increasingly concerned that this expansion will end like the last two, with a collapse in asset prices that brings down the economy. That concern will lead the central bank down the path of excessive tightening. Worse, that logic misses a key point. In both of the last two cycles, there was a sizable imbalance in the economy that extended beyond financial assets themselves. So far, the current environment lacks such an imbalance. That suggests the expansion ends with more of a fizzle than a bang.

Investment activity illustrates the lack of imbalances in the economy relative to the last two cycles. In both cases, climbing asset prices filtered through to the real economy in the form of a growing share of investment spending:

To be sure, the underlying dynamics of the past two asset price booms differ in that the information technology bubble of the late 1990s resulted in a surge of nonresidential investment spending:

While, of course, the housing bubble of the last decade shows up in residential investment:

What is obvious now is that neither source of investment spending suggests a substantial imbalance in the economy. Indeed, the share of investment spending overall has yet to even regain the low that followed the 2001 recession.

Turn to employment for another example of how an asset price rise can impact the real economy. During the tech boom, computer-related jobs were surging. Now, not so much:

Recall recent concerns that the tech industry was caught in the throes of another bubble. But if it was a bubble, it has been quietly deflating since 2015. If such a bubble is to be found anywhere, it would be in California, the epicenter of the technology industry. And note that job growth in the computer-design sector has now petered out:

If that was a bubble, it is collapsing and not taking the economy with it.

The central point is this: High asset prices alone do not imply that a fall in those prices will bring the economy down. Those asset prices need to be linked in a very tangible way to a fairly significant and widespread imbalance in the economy for their decline to bring about a broader economy collapse.

Even if housing or equity prices are now, in the words of Fed Chair Janet Yellen, “somewhat rich,” they aren’t generating the types of economic activity associated with similar bubbles in the past. That suggests that a decline in the those prices, should they occur, will not trigger the kind of broader economic recession experienced in the last two cycles.

Remember the economic recession that followed the October 1987 stock market crash? I don’t either, because it didn’t happen. There was no widespread imbalance in the economy at the time to translate that asset price decline into a recession. What happened instead was that later smaller shocks -- such as the ongoing savings and loan crisis and the oil price surge associated with the war with Iraq -- coupled with restrictive monetary policy to slowly drag the economy into a mild recession. More than anything else, the expansion of the late 1980s simply fizzled out under the weight of a tight Fed.

The current expansion is most likely to end the same way. The economy doesn’t appear to be under the influence of a substantial imbalance that would end like the past two cycles. Unless such an imbalance arises, this expansion will end in a recession much like the mild one of 1990-91 brought on by a Fed that tightens too much or doesn’t loosen fast enough. Much more of a fizzle than a bang.

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