In my last column, I suggested that real estate values were not reflecting an asset "bubble" of emotionally driven price gains unjustified by prevailing economic conditions.  Enterprise values, which are reflected in stock prices, also are justified by prevailing economic conditions at this time. 

Technology stocks surged in the latter 1990s as households doubled the percentage of equity assets they normally held.  That was a bubble.  However, the subsequent 70 percent drop in NASDAQ prices and a nearly 30 percent decline in the S & P index in the past three years appear to have removed the bubble. 

To be sure, investors are paying a high price for earnings and housing, but the finance charges associated with that house purchase and the returns on stocks relative to alternative investments, such as bonds, are appropriate for prevailing interest rates. 

At the same time, I noted that ample liquidity exists to support excess asset valuation.  (While such excesses are necessary to create an asset bubble, it does not automatically mean that one will develop.  Government liquidity, in the form of currency, may only be supplanting reduced bank created liquidity if depositors lose their desire to hold bank deposits.)

Which leads us to whether bond prices have become excessive.  Did the stock bubble shift to the bond market?

Historically, such shifting of excess valuation from one asset class to another is highly unusual.  Indeed, the emotionally driven asset class that is bubbling up normally starves other asset values.  Thus, English land prices were dropping as the South Seas were being bid up to ridiculous prices per acre.  These distortions in relative asset values contribute to the subsequent economic weakness when the bubble bursts. 

Yet, there are signs that quick efforts to stem the fallout from this bursting bubble prevented the collapse of liquidity that normally follows.  (Normally, financial institutions are seriously harmed and depositors are fleeing, such as occurred during the Great Depression.)

I think those aggressive policies were correct.  Why should borrowers fear the loss of loan support because the banks are in trouble?  We have seen enough fallout from such behavior in Japan in recent years and do not need to learn a similar lesson here. 

Nevertheless, by preserving bank lending capacity, these policies allowed some shifting in speculative behavior.  In the British Isles, speculation appears to have flowed to housing.  There, you can get a bank loan on your signature to use for a down payment on a house that has not yet been built.  The speculator hopes that by the time the building is completed, prices will have increased so much that the house can be sold, all debts can be paid and a tidy profit can be earned.  The result is a building boom that greatly exceeds the growth in households to occupy all those newly built units. 

U.S. housing is not being built faster than it is being occupied.  Some apartments are being emptied as low interest rates push monthly finance costs for home ownership below monthly rents.  This will create some problems in apartment development, but construction already is slowing there. 

When prices on the ten year government bond rose so high that yields declined to less than 3.1 percent, a new explanation was coined…deflation.  Remember, new justifications for supporting rising asset prices is a warning that those prices may no longer be appropriate. 

Fortunately, information rapidly develops to justify or refute inflationary expectations.  Rising insurance rates and higher health costs belied the discussion of deflation.  A falling dollar also is incompatible with deflation.