Bitcoin’s price plunge provides lesson for policymakers

Bitcoin’s spectacular recent price collapse should serve as a timely reminder to policymakers that asset price bubbles have the inconvenient habit of coming to abrupt ends.

This is an especially helpful reminder at a time when the world is experiencing a global “everything” asset and credit market bubble that is premised on the erroneous assumption that interest rates will stay low forever. It would also appear to be a useful reminder at a time when President Biden’s excessive budget stimulus is soon likely to lead to economic overheating that will cause interest rates to rise. 

Driven by a speculative frenzy reminiscent of the 17th century tulip mania, Bitcoin’s price rocketed from around $7,000 at the start of 2020 to a peak of over $60,000 by mid-April 2021. More dramatic yet was its spectacular price decline over the past month that was prompted by a regulatory crackdown in China and by Elon Musk’s clarification that Tesla after all would not accept Bitcoin’s in payment for its vehicles. Within a matter of weeks, Bitcoin’s price halved to below $30,000, thereby wiping out around $500 billion in value from this market.

Being held mainly by non-financial private sector investors, Bitcoin’s recent price collapse is unlikely to send ripples through the global financial system. But the same cannot be said should today’s global “everything” asset and credit market bubble burst. This would seem to be the case considering how very much more pervasive are these bubbles than was the case in 2008, when the bubbles were largely confined to the U.S. housing and credit markets.

The truth is that the reduction in interest rates to their zero bound and the unprecedentedly large increase in the size of the major central banks’ balance sheets in response to the COVID-19 pandemic has forced investors to stretch for yield. Not only has this led to equity and housing market price bubbles around the globe. It has also led to a marked increase in lending to risky borrowers in both the advanced and the emerging market economies at very low interest rates that do not adequately compensate the lenders for default risk.

An examination of equity valuations provides a clear indication of the amount of froth in the U.S. equity market. As measured by the Cyclically Adjusted Price Earnings Ratio, today’s U.S. equity valuations are more than double their long run average and are now at levels similar to those prevailing on the eve of the 1929 stock market crash. Similarly, signs of a bubble in the U.S. housing market are provided by the fact that over the past 12 months, U.S. housing prices increased by 12 percent, or at their fastest pace since 2006. 

One indication of the global credit market bubble is provided by the fact that the interest rate spreads on loans to the riskiest U.S. corporate borrowers are now at close to their all-time lows. Another indication is that capital has continued to flow to the emerging market economies at low interest rates despite that in the pandemic’s wake, these economies’ public finances have never looked worse than they do today. 

The Biden administration’s highly expansive budget policy at a time that there is a very large amount of pent-up demand in the economy heightens the risk that today’s asset price and credit market will come to an early end. It does so by heightening the chances that the U.S. economy will overheat by year end, which would force the Federal Reserve to raise interest rates to meet its inflation objective.

In its recent financial stability report, the Federal Reserve acknowledged that some asset price markets were characterized by froth and some hedge funds were excessively leveraged. It also cautioned that asset markets could experience large price declines that could raise financial stability concerns.

This makes it all the more difficult to understand why at this late stage in the asset price cycle the Fed continues to buy $120 billion a month in U.S. Treasury bonds and mortgage-backed securities. By so doing, it risks further inflating today’s asset bubbles, thereby setting the U.S. economy up for a hard lending when the Fed is eventually forced to raise interest rates.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.