Why Bubbles Are Great
for The Economy
By Daniel Gross
Collins; 232pp; $22.95
The Good A breezy and perceptive argument that creative destruction and bubbles go hand-in-hand.
The Bad This thesis isn't really novel, once constituting a major tradition within economics.
The Bottom Line Canny and readable, propelled by brief histories of several transformative euphorias.
Legendary value investor Jeremy Grantham is worried. The founder and chairman of GMO, a Boston-based global investment-management firm with $145 billion in assets, believes we are in the grip of the first worldwide bubble in history. "From Indian antiquities to modern Chinese Art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips, it's bubble time," writes Grantham in his latest newsletter. "Every bubble has always burst," he warns.
Ruptures of market bubbles are among history's most brutal financial calamities—and make for some of its most fascinating stories. Famous booms and busts include the Mississippi Scheme of 18th century France, railroad fever in 19th century America, and the stock mania of both the Roaring Twenties and the dot-com era. The details vary wildly, but major bubbles share some common traits. The exuberance set off during periods of rising asset prices and economic prosperity eventually swells into a speculative frenzy. "Something, it matters little what—although it will always be much debated—triggers the ultimate reversal," wrote John Kenneth Galbraith in his delightful A Short History of Financial Euphoria. "Thus the collapse. And thus the rule, supported by the experience of centuries: The speculative episode always ends not with a whimper but with a bang."
Sounds bad, right? Well, I can imagine journalist and author Daniel Gross responding with a cheery "bring it on!" Gross is the author of the breezy and perceptive Pop! Why Bubbles Are Great for the Economy. He argues a simple theme well: A bubble is capitalism's way of rapidly transforming an economy during periods of major technological and commercial innovation. Creative destruction and bubble dynamics are two sides of the same coin. "The stuff built during infrastructure bubbles—housing and telegraph wires, fiber-optic cable and railroads—doesn't get plowed under when its owners go bankrupt. It gets reused—and quickly—by entrepreneurs with new business plans, lower cost bases, and better capital structures. And when new services and businesses are rolled out over the new infrastructure, entrepreneurs can tap into the legions of users who were coaxed into the market during the bubble."
Case in point: the dot-com boom and bust. The stock market soared into record territory; dot-com valuations reached stratospheric heights; venture capitalists funded countless enterprises; and established blue-chip companies rushed to learn the businesses. However, when the bubble burst, NASDAQ and Internet stocks plunged by nearly 80% and 90%, respectively. Countless hotshot outfits with snappy names like eToys and Kozmo.com failed. Dot-com seers and New Economy enthusiasts were routinely ridiculed.
What the bubble moralizers missed is that the building blocks for an online, Information Age economy were assembled at quicksilver speed. Many good companies got funded, and they not only survived but thrived. (Think Amazon. (AMZN)). Lots of business models and ideas were tested in a Darwinian marketplace. Internet commerce has surpassed even the starry-eyed forecasts of the 1990s, as Google (GOOG), MySpace.com (NWS), and other Web-based innovators emerged from the dot-bomb rubble.
Gross's thesis isn't novel: This point of view once represented a vibrant tradition among economists, including both Karl Marx and the legendary Joseph Schumpeter. More recently it has been argued by Deutsche Bank economist Peter Garber in his Famous First Bubbles and BusinessWeek chief economist Michael Mandel in Rational Exuberance.
Still, Gross provides a canny and readable account, propelled by brief histories of a number of transformative euphorias. Plus, he offers two other themes. First, that America's version of free-market capitalism is especially prone to the benefits (and the investor losses) of bubbles. Second, that government often plays a key role. For instance, federal aid in the form of cheap capital helped the railroad boom along. In example after example, he argues that "government, through tax credits and patent policies, procurement and legislation, the tax code and direct subsidies, has helped foment, incubate, kick off, and sustain these booms."
As for the global economy, we are living in a remarkable age. Much of the bounty that had been confined to a handful of nations is spreading to China, India, Vietnam, Mexico, and other emerging markets. Grantham is right. The boom will go bust, but meanwhile durable bridges of trade, capital, and knowledge are being built. Every day the ideal of a global economy becomes more of a reality and less of a goal.
By Christopher Farrell