Telling good bubbles from bad

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I’m participating in a discussion over at the TPMCafe Book Club on Dan Gross’s Pop! Why Bubbles are Great for the Economy. Because I’m such an environmentalist, I figured I should recycle my first post here:

This book is a wonderful counterweight to the mostly finger-wagging historical literature about bubbles. The idea that irrational exuberance can build industries and spark economic growth in a way that fully rational investing would not is one that deserves a lot more attention from economists and historians.

But it seems pretty clear to me that not all bubbles are created equal. Of the six bubble episodes described in detail in the book, four support the bubbles-are-grrreat theory pretty strongly (giving you a stupendous .667 batting average!): the telegraph, railroads, the Internet, and alternative energy. In each of these cases, overly optimistic and sometimes downright nutty investors financed the building of valuable infrastructure that others were later able to put to productive use.

It’s the other two bubbles you cite that worry me.

The positives you cite for the now-deflating residential real estate bubble are pretty lukewarm, as Jesse has already pointed out. Then there’s what happened in the late 1920s, which you characterize as mostly a bubble in financial innovation. You argue that after this new financial infrastructure collapsed, the New Dealers built a new and more durable government backbone for the banking and securities businesses. I’m willing to buy that last part, I guess. But should the 1920s bubble really get credit for it? I mean, a different president than FDR might have reacted to the meltdown of the early 1930s by simply shutting down securities markets for good.

Some bubbles do good, and some probably don’t. So how do we tell them apart? My theory: Bubbles are far more likely to look good in retrospect when they grow out of enthusiasm over a real innovation like the Internet or the telegraph. They’re less likely to look so great when the driving force is financial innovation.

Think about it: Everybody makes fun of the tulip mania that gripped the Netherlands in the 17th century, yet it laid the groundwork for a big Dutch tulip industry that survives and thrives today. Contrast that with John Law’s Mississippi bubble in France a century later. That mania was built upon the purely financial innovation of paper money, and while it certainly provided lots of useful lessons to subsequent central bankers, it didn’t leave the French economy with much of anything but a lasting suspicion of financiers from English-speaking countries.

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