Why Indentifying a Bubble Isn't So Difficult, Gold Crashes, and the Offer to Uncover Rick Perry's Sexual Exploits

John H. Cochrane had an interesting article out a few days ago in Bloomberg titled "Why Identifying a Bubble Is So Much Trouble." 

We seem to be surrounded by “bubbles” -- tech stocks, real estate, and now maybe sovereign debt.
You might expect that any textbook would have a precise definition of this phenomenon; some set of characteristics that distinguish sensible high prices in good times from prices that are “too high” or in a “bubble.” Alas, “bubbles” seem to be in the eye of the beholder.
Does that mean it’s all just empty talk? No, and there is solid academic research that helps us to think about what “bubbles” might mean, and how both policy makers and investors might think about them.
Here are the central facts: High valuations are, on average, followed by many years of poor returns, and vice versa. High valuations are not, on average, followed by years of good cash-flow growth, or by ever-higher valuations.

Question #1: Where does the cash/credit come for to fuel the new high valuations?  *crickets*

This fact holds across markets:
-- High stock price/dividend, price/earnings, or market/book ratios are on average followed by years of poor returns, not years of higher dividend and earnings growth, or permanently higher prices, and vice versa for low prices.
-- High yield spreads (low prices) on long-term bonds are on average followed by good returns on long-term bonds, not by increases in short-term interest rates, and vice versa.
-- High credit spreads (low prices) on low-grade debt are followed, on average, by good returns on that debt, not a proportionally high bankruptcy rate, and vice versa.
-- High interest rates abroad relative to the U.S. are followed, on average, by good returns to U.S. investors in that debt, not by foreign exchange-rate depreciations, and vice versa.
-- High house prices relative to rents are followed, on average, by flat or declining house prices over many years, not by increases in rents, and vice versa.
No one substantially disputes these facts. The question is: What does all this tell us about why prices are high or low in the first place?

Correct (to my very limited knowledge) so far, no mention of who centrally dictates those interest rates.

The “macroeconomic risk” view holds that the discount rate for a given cash flow can vary over time. Price booms come in good macroeconomic times, when the average investor is “searching for yield” and willing to take on some extra risk. Such investors bid up the price of unchanged cash flows.
Price busts come in horrible macroeconomic times, such as those we are enduring. In these periods, the average investor may rightly say, “I understand returns are better going forward, and there is the buying opportunity of a lifetime in junk bonds. But I’m about to lose my house and my job, the bankers are about to shut down my business, and I can’t take any extra risk right now.” Such investors drive prices down until the same prospective cash flows can deliver returns large enough to overcome their justified fear.

Well there he went and did it, Cochrane put the cart before the horse.  Busts don't come in bad economic times, they are the cause of so said bad economic times.  Still no mention of the gigantic elephant of a central bank in the room.  No mention of credit expansion and fractional reserve banking, those are just realities we must ignore.  But wait, maybe he is starting to get at it:

The “irrational” view is that investors’ required returns don’t change, but they simply get it wrong. Sometimes they get over-optimistic and bid up the price as if cash flows are going to be great. Sometimes they get irrationally depressed. In either case, they don’t learn from the centuries of experience.

You can almost hear him straining to type out "malinvestment" but just can't seem to make the connection.

A new view says market swings are all about financial frictions, not mass risk aversion or psychology. In the financial crisis many assets seemed to fall in value because of the run in the shadow banking system, or temporary illiquidity in markets. The question is whether this view can explain broad movements across many directly held assets like stocks, or whether it’s confined to specific smaller markets.

Hey how bout that new "view" Ron Paul keeps bringing up in the GOP debates?  Something about Austrian economics and the boom bust cycle created by central banks lowering the interest rates and printing money?

Research has, at least, given a lot of structure to the “bubble” question. We know that variation in price ratios corresponds to discount-rate variation, not to changes in expected cash flows or the ability to find a greater fool. The challenge is to understand that discount-rate variation. A focused debate, based on clear facts and explicit theories, is real progress.

Research huh?  How about Murray Rothbard's research on the Great Depression?  How about the multitude of Austrian economics who recognized the housing bubble and its cause?  Think it might be a good idea to perhaps look at what they had to say Cochrane?  Or is Bernanke too much of a sacred cow?

Speaking of bubbles, it would be interesting to see if Cochrane saw this coming:

China's papers are calling it their "own subprime crises."

According to Shanghai Daily, 7 large business owners, mostly manufacturers, fled the city of Wenzhou on September 12th. They left thousands of employees jobless and hundreds of millions in unpaid debt.

This is one of the consequences of China's "black bank," the massive undergound banking system that has been growing at a dizzying pace since the government started tightening credit to curb inflation.

No doubt he will place blame on the underground banking system rather than the institution that made credit addicts out all the small towns, cities, and businesses in China that relied on the continuing infrastructure buildup for property tax revenue and income.  Looks like the crash is in full throttle, not good for the world economy considering Europe is just barely hanging on.

Also in potential bubble news, we have gold taking a beating today:

While this will surely get the anti-barbarous relic crew in a tizzy, here is the explanation:

CME just hiked gold margins by 21%, silver by 16% and copper by 18%. Mystery solved.

Way to be a party pooper CME.  

Last night's GOP debate was a pretty big disappointment but it looks like the race is about to get a lot more interesting:

SAN FRANCISCO (Reuters) - Pornographic magazine publisher Larry Flynt offered $1 million on Thursday to anyone with proof of "an illicit sexual liaison" involving leading Republican presidential candidate and Texas Governor Rick Perry.
The offer by the politically left-leaning Flynt targeting Perry was similar to past efforts by the Hustler magazine founder to embarrass public figures he dislikes.
Los Angeles-based Larry Flynt Productions, which publishes Hustler, said it bought full-page advertisements in the weekly editions of the U.S. satirical tabloid The Onion and the Austin Chronicle, a Texas alternative paper, seeking evidence of any Perry peccadilloes.

Not to discriminate against Perry too much, I would like to see dirt on every candidate, including Obama.  It's funny that Flynt sees Perry as a threat and singles him out.  Certainly some news on the sexual exploits of any candidate would be great.

I will end with this cool chart on the Fraser Institute's Economic Freedom Index:

No surprise here, I am gonna have to look more into the index though.

Update- Easily the funniest thing I have read all day, via Tyler Cowen:

Some people on Twitter were taking about “striking down Old Ben and having him come back stronger,” but a) Obi-Wan plain, flat out died, b) Obi-Wan’s younger prodigy, Luke, was a failure who relied on his dad and wouldn’t at the key moment listen to Old Ben and stay on the Dagobah system to invest in additional human capital (instead he read Caplan on the signaling model), and c) they never even made the final three movies of the planned nine, so we don’t know how it turned out with the unwinding of the fiscal stimulus on the Ewok world.  People, next time get your facts straight!