Pop!: Why Bubbles are Great for the Economy

Bubbles leave behind an economic infrastructure that spurs later growth.  The telegraph and railroad bubbles of the 19th century gave birth to modern communications and transportation.  The fiber-optic bubble of the 90s paved the way for YouTube and MySpace.  Might we need a "green bubble" to solve current energy problems?  So argues Daniel Gross, Slate.com and NYT columnist, and also blogger.

I can think of two mechanisms:

1. The bubbly asset price spurs overoptimistic innovators, thus counteracting the tendency to underinvest in new ideas (which are public goods to some extent)

2. The bubbly asset price spurs clusters of production, which help overcome the fixed costs of innovating with a new technology.  I am reminded of Andrei Shleifer’s seminal work on implementation cycles.

Of course Gross is smart enough not to defend all bubbles.  Perhaps bubbles are best when an economy has the potential for breaking through to a new high-growth mode; that would cover today and the mid- to late 19th century.  I am less convinced by his treatment of the 1920s bubble, which he cites as beneficial in paving the way for the New Deal.  I see a smoother economic path as having brought the better parts of the New Deal without so many of the overreactions.

Gross argues that government should support many bubbles instead of choking them off.  At the very least, bubbles are underrated.  This is a stimulating book, worth your time and money. 

I am of course interested in the cross-sectional cultural contrasts.  Paintings are resold for profit, and they are possibly bubbly assets, but CDs are not.  Does that make the artistic market more supportive of innovation than the music market?  Are bubbles beneficial in the auctions for book contracts?  Was this book the result of a bubble?

Here is an FT review.

Comments

I would argue that the only good bubbles are productive-driven bubbles. The bubbles in railroads in the 19th century and telecom-internet in the 1990s have been good for the economy because there was a clear path to substantial improvements in national productivity. Whereas the Dutch tulip bubble and the now past bubble in real estate were not good bubbles because the effect was just wealth transfer from buyers to sellers with no improvements in productivity.

If you lived in Philadelphia you wouldn't dismiss the real-estate bubble so quickly. Neighborhoods that were neglected for decades have started to see investment - and private investment, as opposed to the heavily subsidized housing we've seen in the past. Much of it is undoubtedly overpriced, and many of the investors will be disappointed when the pop comes. But one result is a new influx of middle-income residents who are less inclined to support the city's old-line, rent-seeking labor/political class in local elections. You wouldn't necessarily want to be a participant in this bubble, but it's worth cheering on from the sidelines.

Wouldn't Gross's "green bubble" be a lot more like the Apollo program than a true bubble?

Apollo involved vast amounts of federal funding & control to reach supposedly important national goals that ultimately were dead ends. Yes, a basic space-industrial capicity was created, but that lead in turn to other dead ends like the Space Shuttle and a general discouragement of private space commerce.

And what's the likelyhood that Daniel Gross would support a truly privately oriented bubble, as oppose to a "New Apollo" run by smart technocrats like Daniel Gross?

Does this mean that Krugman is going to stop predicting bubbles every year?

Jason Potts wrote a great article on the role of bubbles as a productive
feature of capitalism several years ago in an Australian economic policy
magazine. I think the article was called "Liberty bubbles".

Just wondering, other than asthetics, did Holland's tulip bubble have any positive aspects?

I'm not persuaded that sparking the New Deal, aka the massive socialization of the American economy, is an argument for market efficiencyr.

What, pray tell, did the new deal fix?

I think I see a version of the "Junker fallacy" previously described here by our hosts. Capital isn't "destroyed" by a bubble. Financial capital is simply calls-on-resources. You could burn the paper or randomize the electrons and no productive capacity has been eliminated.

Now, it is true that productive capacity being created during a "bubble" (i.e. factories, infrastructure) may be allocated sub-optimally with regards to medium-term demand, but I think I can see the point being made here. Imagine that two equilibrium states exist for the economy, A & B, with B being one where there is higher consumption. The trick is, you can't easily get from A to B because none of the individual actors feels like taking the risks associated with investing for state B while state A obtains. The idea here, if I understand it correctly, is that the bubble basically fools everybody into investing for B. There is a deadweight loss, of course, but does it necessarily follow that the deadweight loss must be greater than the gains from moving to equilibrium B? (Maybe it isn't a good process even if the deadweight loss is smaller; you don't know ahead of time that equilibrium B exists, so on a risk-adjusted basis the bubble is a bad idea anyway?)

Yancey,

I suppose an omniscient being might be able to discern states A and B, and know which is better, but I don't know of any of these gods operating in government.

Yancey, surely you jest! Iosif Vissarionovič DžugaŠ¡vili! :^)

(I'm only three-quarters kidding. Presumably there's a similar effect regarding the massive application of capital involved in forced-draft industrialization, insofar as there was a pre-industrial Russian equilibrium and an industrialized equilibrium that the economy couldn't easily get to. And deadweight losses and gigantism inbetween....)

Getting back to music: While there is no bubble in the price on individual CDs, there is very definitely a bubble in individual artists.

When 100 000 people pay $80 to attend the concert of someone like Britany Spears, there is no argument that they are doing it based on the objective assessment of her musical talent. They are doing it because she is popular. The more popular she is, the more other people want to see her concerts and buy her music.

Then 5 years later it's "Britney who?"

We can all make arguments against or in favor of bubbles,
but the main point is that they seem to be an inherent
part of the creative destruction of market capitalism.

this is part of the problem I have with the way economics
is taught in out schools. We teach that markets are efficient
and give the impression that it means markets are not wasteful.
But anyone with any knowledge of how markets really work understands
that markets are virtually never in equilibrium -- they are almost
always overshooting in one direction or another. Generally it is just a matter
of whether they overshoot by a massive amount or just a little.

But this is not to argue that markets are bad or perfect as some want to argue, rather it is just that the are generally better then the other alternatives.

The blog below has some excellent comments about the ethanol 'industry' from a chemical engineer in the oil industry, with a masters degree in the production of cellulosic ethanol.

http://i-r-squared.blogspot.com/

His attention the problems of ethanol, that the promoters are brushing over, is excellent. The core problem remains: for corn-based ethanol, energy out is much less than energy in, including all the inputs of transportation, fertilizer and pesticide, as well as distilling.

(sugar cane ethanol, a la Brasil, is somewhat different)

Biodiesel, which is an economically far more sensible fuel, is an ecological disaster. The problem being the demand for palm oil causes the Indonesians and the Malaysians to bulldoze rainforest.

http://www.biofuelwatch.org.uk/

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