Why bubbles are usually a good thing

Since the stock market crashes in 2001 and 2008 warning for the next bubble has become a popular topic. It seems to be taken for granted that our world would be a much better place if we could avoid those bubbles that “always” end in violent busts… But is that so? What if those bubbles have good effects too? And what if those effects outweigh the short term pains of the bubble bursting? That other side of the coin is rarely talked about, so let’s give it a go.

Yes, some people lose their life savings in a crash. And many people lose their jobs in the economic contraction that typically follows the bursting of a major bubble. No question about that. But that’s only one side of the coin. Here are a few other things to consider:

1) If I spend all my life savings to buy a few tulip bulbs from my Dutch neighbor, then I may lose all my savings when the bubble ends, but the money did not disappear. My savings have just gone from my pockets to somebody else. The amount of money in Holland did not change because of the tulip mania. The only thing that happened is that some speculators lost and others won what their less fortunate colleagues lost. Just trading gains and losses. And some of those who won a fortune may have used that capital to start great productive companies that created jobs and value for decades. Companies that may not have existed without the tulip mania. We just don’t know because we can’t see it. The stories of the families who lost everything in that bubble are the more visible and spectacular effects, so that’s what is most prominent in the records and the memories left from that time. But the real question is: what is bigger? The short term pains caused by the crash? Or the long term benefits from the investments that were done in the preceding boom? And even the pains of the crash may have had beneficial effects in the longer term, more on that below.

2) People lose their jobs in the economic contraction that may follow the bursting of a bubble. True. But without the boom that preceded the bust their job may not have existed in the first place. Would they have been better off if a 10 year bubble followed by a crash had somehow not happened? Most of those people may have had a significantly lower standard of living for that entire 10 year period in the parallel universe without that bubble. Let’s not forget, when speculators throw money into the latest innovative idea then a lot of that money goes straight into wages for the employees that are being put to work to build the new product or services. This is one of the main sources of “trickle down” (money flowing from the very wealthy to the poor) and that would be partially cut off if we somehow stop bubbles. Countries like Cuba have not had any bubble for decades, simply because any form of speculative investment was forbidden. But that hasn’t led to higher prosperity. The problem is that if we stop speculative investment, and thus bubbles, we also put the brakes on innovation and risk taking.

3) The famous tulip mania made a lot of families poor. Of course it also made a lot of people very rich, and keeps doing so until this day, but they are not talked about. Almost 400 years later, Holland is still producing about 93% of all the flower bulbs in the world, employing some 20,000 people: http://pss.uvm.edu/ppp/articles/dutch.htm

That’s not a coincidence. I think something psychological happens when a lot of people lose most of their savings in some speculative mania. Some of them give up and never recover, but most people are stubborn and will grind their teeth and mobilize all their energy to make it work out in some way or other. This is the well known “what doesn’t kill you makes you stronger” concept. That grit worked for some of them, and later allowed them to keep dominating the flower bulb industry for centuries. The tulip mania had been a blessing in disguise for the country. Just like centuries later the dotcom bubble became a blessing in disguise for the surviving internet companies.

4) The railway mania in Britain is another classic example of a speculative bubble. Reports of those days focus on the middle class families that lost their savings in the frenzy. But the countless lower class people that got jobs building railroads at a frantic pace for 10 years are barely mentioned. And even though many railroad companies went belly up, leaving investors with a total loss, most of the railways they made proved very useful and economically beneficial for decades to come. We can calculate the loss for investors when their stocks went to zero. But we cannot calculate the long term economic benefits for a country that had extensive railroad network much quicker than would have been the case without the railroad bubble.

5) There is the popular assumption that central banks are responsible for blowing bubbles. I think that is both right and wrong. Central banks generally try to prevent bubbles by raising interest rates when the economy gets too hot, and then try to soften the blow when the bubble bursts by quickly lowering rates. They do this to maximize the profits of their good friends the bankers and to protect them from catastrophic loss when things go wrong, all the while telling the general public that it is all for their own good. The problem is that this strategy has the paradoxical effect of making bubbles bigger and longer because the market participants (both banks and private investors) start taking bigger bets, assuming that the central banks stand ready to save the day when needed. Investors and banks would be a lot more careful if there were no central banks to come to the rescue. So, the problems caused by central banking have become the reason why we “need” central banks. They are basically a dog chasing its own tail. We would have a more stable economy without them and we would have more bubbles, good bubbles. The bubbles would simply run their natural course, leaving us with useful new infrastructure and new products as quickly as “innovation + speculation” makes them possible.

6) Some observers contend that we are getting more and more bubbles because the central banks are interfering more and more with the free market. It is true that we see bubbles more frequently than a century ago. And it is true that central banks have become more active in the last 50 years. But correlation is not causation. And it is clear that there have also been bubbles when there were no central banks.

I think we see more bubbles, not because of central banks, but because of more rapid innovation in every scientific field. Most bubbles evolve around some radically new technology or new discovery, which gets investors so excited that they cannot stop themselves from putting a big portion of their savings into it. And that is a good thing, even though it will hurt some investors when the bubble bursts. Because a speculative bubble helps to build the given innovation as quick as the given community can build it by putting most of its savings into it. The economic benefit of making a disruptive new technology available very quickly can easily dwarf the financial loss that will eventually come (and go) when the bubble bursts. At the end of the day the true prosperity is always in the products and services that are built in a country, and money is secondary.

Bottom line: when judging the effects of bubbles we shouldn’t just look at the most obvious superficial effects like individual loss of savings and loss of jobs, but also at the deeper long term effects in terms of real value that was created. Factories, railroads, internet cables, houses, technology…. that were built or developed during bubbles have frequently found a good use afterwards. Sometimes for a different purpose than originally intended, but useful anyway. It is real capital that remains. It will find an owner and it will find a use. People sitting on their hands during what-would-be-bubble-years would not create anything. So, countries without bubbles tend to lose vigor, new jobs become scarce, and the population starts struggling to pay for the upkeep of the existing homes and factories. Next they descend into shortages and social stress and then you have a “poverty bubble” or worse… Is that more desirable?

I would rather have speculative bubbles. At least something useful may get built. And when it’s build it’s there to be used, and it doesn’t matter what has happened with the investors’ money.