2011 May 01 Sunday
Market Bubbles Better Than No Market Bubbles?

Is irrational optimism necessary for progress?

Some economists such as Jaume Ventura and Alberto Martin of Barcelona's Universitat Pompeu Fabra go so far as to argue that bubbles are the price we pay for vigorous growth. They say the optimism reflected in sharply rising prices can become a self-fulfilling prophecy: Rising prices induce more hiring and investment. That generates the growth that justifies even higher prices, and so on in a virtuous upward spiral. Of course, eventually the bubble pops and causes a mess. Yet however jarring a boom-bust economy may be, they say, it's better than an overregulated economy stuck in perpetual underperformance. "The bubble has costs. But you prefer the world with the bubble over the one without the bubble," says Ventura.

Most businesses fail. If optimism didn't spring eternal we wouldn't get as many attempts at starting businesses and the smaller number of super successes would come less often.

Jeremy Grantham, Co-founder and Chief Investment Strategist of Grantham Mayo Van Otterloo (GMO) - with $107B under management, writing in a bleak article about Peak Everything points out that optimists do better in life in spite of the fact that they cause market bubbles.

Fortunately, optimism appears to be a real indicator of future success. A famous Harvard study in the 1930s found that optimistic students had more success in all aspects of their early life and, eventually, they even lived longer. Optimism likely has a lot to do with Americaís commercial success. For example, we attempt far more ventures in new technologies like the internet than the more conservative Europeans and, not surprisingly, end up with more of the winners. But optimism has a downside. No one likes to hear bad news, but in my experience, no one hates it as passionately as the U.S. and Australia. Less optimistic Europeans and others are more open to gloomy talk. Tell a Brit you think theyíre in a housing bubble, and youíll have a discussion. Tell an Australian, and youíll have World War III. Tell an American in 1999 that a terrible bust in growth stocks was coming, and he was likely to have told you that you had missed the point, that 65 times earnings was justified by the Internet and other dazzling technology, and, by the way, please stay out of my building in the future.

Look at the German software industry (if you can find it) as a comparison to the US software industry. The Germans ought to be able to spin up lots of highly successful software companies. But no. It takes irrational exuberance (like with the current Silicon Valley social media bubble) to produce excellent companies that are game changers.

What's key: Some investment bubbles (notably in tech) are constructive. They throw up lots of experiments and a few work. Other investment bubbles (mostly involving finance and excessive loans) are destructive. They pull people away from constructive work and misallocate capital with no long term payoff. The excessive real estate build in the US, Ireland and some other countries did not make these countries richer in the long run - quite the opposite.

So have our bubbles become more destructive on average? If so, why?

Share |      By Randall Parker at 2011 May 01 01:24 PM  Economics Creative Destruction

poor pete said at May 1, 2011 1:31 PM:



REN said at May 1, 2011 6:30 PM:

After reading this I had to smash my head in the wall several times. I think a lot of economists must be on crack, or they really donít understand the monetary system. Our colleges are producing a lot of highly educated people who now a lot about nothing.
We have bubbles because 97% of our money originates as credit. I prefer to call it a debt money system. When you go to the bank to take out a loan, they monetize you. They do not borrow from somebody else to give you the loan. The new money pops into being right then as a double entry ledger. That new money is credit money and stands in for real money. Credit money has debt attachedÖ a significant amount of debt attached. For example, if you take out a house loan for 100K you might have to pay an additional 200K in interest. The capital costs then would be 200%! The overall cost of our debt money in our economy is about 40%. This is a tax on the productive, and that money shifts to a growing plutocracy. These same plutocrats are the tail that wags the dog, and their money power has undermined our Republic.

When a bunch of people get all excited and inflate a bubble, the bank loans out credit money because the underlying asset appears to be increasing in value. Our housing bubble is a case in point. You could never go wrong with buying a house because it always went up in value, right? When the bubble pops, the bankers look at the balance sheets and squirm, because the underlying asset fell down in value, but the numbers on their balance sheet remain. That is why we are in a balance sheet recession right now. The bankers then whine to the government about their tenuous position, and then the government has to inject base money into the supply, increasing the money supply. Hopefully the new government money (not credit money) is enough so that people can eventually pay down their loans. Remember these loans popped into existence due to a bubble. Increasing the money supply in this way causes inflation, so now everybody has to pay the price.

It has taken Japan 15 years to pay down their bubble from the mid 80ís. When the bubble from the 20ís collapsed it caused a world-wide depression. For the life of me, I cannot understand why economists prefer credit to actual money. Most of them cannot see the forest for the trees. Credit (debt money) is a poor stand in for real money.

REN said at May 1, 2011 6:34 PM:

Germany got out of their hyperinflation (which was caused by a credit bubble from their private banks, and bear raid by foreigners) by state intervention (issuance of MEFO bills). In only about 8 years Germany went from being broke to being the richest country in Europe. This was not done with damn credit money. It was done with State money. England used tally sticks from 1100 to 1694, which was a form of debt free money. England built out their economy debt free for over 500 years. In 1694 the Bank of England was privatized, issuing credit money like crazy, which put the population into debt slavery. The BOE tried to hose down the American colonies with debt which ultimately led to the revolutionary war. The U.S. won the revolutionary war with debt free Continentals. Continentals were counterfeited by the British by the millions, so they now have a bad rep. Lincoln won his war with debt free Greenbacks, and there was an explosion of innovation in the North. Additionally, the North got richer during the war despite all the destruction. During WW2 the U.S. issued new money directly into industry at 3/8 of 1% interest. We fought the war, building out industry, and not building debt with a bubble. Canada for 1932 to 1974 used their State bank to fund the War, and then build a national railroad, canals, free education, land grants, etc. Canadian industry was able to save so much money they stopped borrowing, and became self financing.

History shows us it is the exact opposite. When you DONT use credit money, your economy explodes with activity. How is it that dragging around debt money in every transaction is an efficient way to allocate goods and services? How is it that putting your population into debt servitude somehow makes things better?

By the way, our bubbles are more destructive now because wall street has financialized everything in their avaricious greed. Even food is driven up and down in apparent value, as they insinuate themselves between the producer and the buyer. People need money that is stable and a source of value so they can see holes in the market. With credit money going up and down in value it like a virus in our capitalistic system. With improper feedback we function poorly and cannot properly price goods and services. Today humans are producing an explosion of real wealth. By all rights we should only be working about 20 hours a week for the same living standard. Imagine what an increase of new thinking and creativity would happen if half the population was imagining and playing, instead of slaving to pay off debt? I want to give some of these economists a giant supersonic wedgie. Give me a break. We donít need bubbles to be creative, we need stable money and time and a desire to do better in life. We need a government that doesnít hinder us, but instead supports us.

Dan said at May 1, 2011 6:57 PM:

Frankly, I think if you squint your eyes and turn your head sideways you can see the US housing bubble as not such a bad thing.

(1) At least we Americans get to collectively keep all the houses that got built. I got a great house at a decent price after things went down and my family may live here for many years. We've already added two children here to the one we already had.
(2# We had a huge surge in foreign capital looking for a home ;) and there worse places to store capital than in houses. One example of a worse place to store capital is where it is all going now, the global sovereign bond markets. Good luck to us trying to pull that value back out!
#3) Americans by and large enjoyed a higher standard of living in the 2000s than ever before. If you party like a rock star, at least have a hang over like a rock star, by feeling good about the good times you had, even as you hold your pulsing head in your hands. For real rock stars, past good times were worth in retrospect, even though those good times aren't here anymore.

bbartlog said at May 1, 2011 7:27 PM:

REN is correct. You're viewing bubbles as an unfortunate side effect of basically well-intended policies, when what you really have is a system of finance that desperately needs bubbles in order for the avaricious to prosper, and thus creates them one after another regardless of the damage. 95-99% of the profit in banking is ultimately parasitic.
So far as software is concerned, Germany and also Japan have a cultural problem in that they focus too much on quality even when this is not what the situation demands. It's not a bad instinct in general (Germany is the world's top exporter, after all, and Japan isn't weak on that front either), but in software the first mover advantage is often enormous, so that what you really want is to ship an acceptable product as fast as possible.

'you can see the US housing bubble as not such a bad thing.'
Yes, if you compare it to the alternative reality where all the resources used to build those houses were simply absent, it looks sort of good! But with a slightly greater exercise of imagination, we might think of what those untold millions of man-hours and billions of dollars could have accomplished instead, had they been allocated differently.

REN said at May 1, 2011 8:50 PM:

So, why didnít the Germans produce great software, or even high tech in the 80ís. Because the U.S. has the reserve currency, and Germany is a mercantilist power. Germany always has more exports than imports. That way they can export to large markets and have scale to drive down their unit costs. In the 80ís Germany exported goods to the U.S. and we exported dollars to them. Reagan deficit spent base money (government money) into the economy which meant there was enough extra money for savings in our private sector as well as enough extra money to send overseas for our imports.

The extra dollars held by the Germanís were recycled back to the U.S. to buy treasuries, driving down interest rates. The Germans felt cheated - they sent relatively cheap goods to the U.S. and recycled dollars back to us. We used those cheap dollars to build new high tech industry. Main Street U.S. industry came under price pressure from our mercantilist competitors. The private sector had enough savings since Reagan was deficit spending. See MMT sector balance equations for how this works. Germany focused on their mercantilism thinking they needed to export their way to wealth. Mercantilism means you can hold industry, and perfect it, but not necessarily create new industry. China is also mercantilist, so they will eventually capture and hold markets.

Since we have reserve currency, our policy then and today is to send dollars overseas in what is called dollar hegemony. We deficit spend and have a large trade imbalance to send those dollars outside our economy. This causes a lot of churn in American industry, as we lose to mercantilist competitors. We have to use our cheap dollars to invent our way out and stay ahead. Today we tend to invent, and then export the new industry and not let it develop here.

Personally, all this gamesmanship between countries by using fiscal and monetary policy makes me nauseous. Even today, the rapid run up and down of food prices and commodities is causing people to starve. It would be a simple matter to have a 100 percent reserve real money system. For trade policy we could use bank clearing houses in order to prevent mercantilism. The private sector could save enough money to fund any sort of new enterprise. We donít need private banks creating credit money bubbles. Private banks should only match up creditors and debtors. If the money supply needs expanding, Government can direct spend into infrastructure, or on whatever the people deem important.

Wolf-Dog said at May 1, 2011 10:16 PM:

Irrational exuberance is needed or it is at least very helpful to supercharge waves of innovation. The best innovation in almost all areas are _STILL_ in the US. Silicon Valley is regaining its momentum, as the commercial real estate vacancies have been diminishing.

We shall see what the new bubble will be in Silicon Valley? Electric cars from Tesla's rivals?

A.Prole said at May 2, 2011 12:30 AM:

Actually, Germany has a big and thriving software industry.
They are market leaders in certain business applications.

Stephen said at May 2, 2011 2:43 AM:

Irrational exuberance is equivalent to shoals of fish that are easy prey to the killer whales. A fish about to be eaten is shocked that it wasn't protected by the shoal, but the killer whale is shocked that a fish would just sit there begging to be eaten.

REN said at May 2, 2011 6:38 AM:

The mercantilists will tend to capture industry. Our Semiconductor industry is fairly young, yet it is has already moved offshore to a large degree. So, how does that wave of innovation due to the credit bubble taste to the former Semiconductor employees in the U.S? Not good I suspect.
During the Clinton years, the Graham Leach Bliley act broke the provisions of Glass-Steagall. That meant that insurance, wall street investment banks, and commercial banks could all get incestuous and be counter parties to each other. This allowed a giant wave of %*@% credit money to pop into being. At the same time the corruptocrats in Congress gamed provisions of the Community Reinvestment Act. All this new credit money bubbled into housing, and everybody looked the other way. Lets Party! All of these counterparties were leveraged to each other in a giant ponzi scheme. Yeah thatís just great, lets Ponzi our way to wealth in another bubble. All the land sharks in the financial community were transferring this credit money to themselves and away from productive labor.

It gets even better. Clinton ran a budget surplus during this time. Whenever a government runs a surplus, it is borrowing money from the private sector. Government is issuing less base money than it is bringing in through taxes. Since the average American learns nothing about our money system in our Government schools, they think this is great. The budget is balanced! Yea! But in reality, government is consuming some of that CREDIT money that came into being during the bubble. That credit money is expensive (see my earlier post); so in effect, the government insured a bubble and put labor into more debt. Government grew at the expense of the private sector, and said private sector had their savings reduced by the government spending.

It gets even- even better. Whenever there is a period in history where the government runs a budget surplus, it always is followed by a recession or a depression. Thatís right. In order to keep up their standard of living, the private sector will borrow more %$@# credit money as the government consumes it. Eventually this leads to a crash in the private sector as savings are depleted. We are in that crash now. Since the balance sheets are so upside down in the banks, it will take some time to undo the housing bubble. In the meantime, the dumb-dumb- dumbies in Congress are listening to the bankers and trying to reignite another bubble.

The death and destruction brought on by bubble finance, and the shifting of wealth to the plutocrats makes me want to hurl. Go aheadÖbe for credit money and bubbles. If you are, then you want to be a debt peon and a serf in the coming feudalism.

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