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The Bright Side of Bubbles

Despite their cost, speculative bubbles may have an enormous upside, a new book argues.

The American economy is forever blowing bubbles. Housing seems to be the investment bubble du jour, coming on the heels of the Internet bubble, which popped seven years ago. The two are linked: as the dot-com economy slowed, Federal Reserve Board chairman Alan Greenspan steadily lowered the federal funds rate, eventually to a rock-bottom 1 percent. That cheap credit, in turn, fueled a spectacular rise in home prices, greater than any since the years following World War II.

Yale economist Robert J. Shiller charted that ascent in the second edition of Irrational Exuberance, his classic study of the 1990s stock-market boom. Between 1997 and 2006, real home prices in the United States soared more than 80 percent (see “Up, Up, and Away” at the end of this article). Shiller, who famously identified the Internet bubble, thinks irrational exuberance again was the culprit, pointing out that the Federal Reserve had lowered rates before without triggering a housing bubble. He has said that the housing market could drop by as much as 50 percent in the next decade.

Not everyone is as gloomy. Some think the bubble will deflate gently rather than burst, while others continue to question whether the housing boom is, in fact, a bubble at all. Perhaps prices will level off at a new plateau, as they did after the 1940s boom. Or, perhaps, people will soon be recalling another Yale economist, Irving Fisher, who proclaimed shortly before the 1929 crash: “Stock prices have reached what looks like a permanently high plateau.”

Bubbles, unfortunately, can be verified only after they burst. There is no academic consensus on the status of bubbles; indeed, economists debate whether it is meaningful to talk about bubbles at all, particularly from a public-policy perspective. (“The Fed cannot reliably identify bubbles in asset prices,” said Fed chairman Ben Bernanke in 2002. And even if it could, he added, “monetary policy is far too blunt a tool for effective use against them.”) Still, many observers say that speculative bubbles have obvious hallmarks: skyrocketing prices that defy market fundamentals, increasing speculation, participation in the market by people who normally don’t get involved in such things, even a tendency to permeate various aspects of popular culture.

Bubbles in the Long Run

Despite the fear and trembling over what certainly looks like a housing bubble, there is a more optimistic way to regard it: as further evidence of a competitive advantage for the American economy. That’s the novel view of bubbles offered in a contrarian new book by Daniel Gross, Pop!: Why Bubbles Are Great for the Economy (HarperCollins, May).

Gross is a financial journalist and commentator (and past contributor to CFO) who regularly writes for The New York Times and the online journal Slate, as well as his own blog. A critic of the contemporary business scene and author of previous books on American business history, Gross isn’t a Pollyanna; he’s well aware of the widespread misery and financial ruin that followed the bursting of previous bubbles. But he writes that while the misery has been amply chronicled, the positive side of bubbles has received little attention. “One can’t help but think that the sackcloth-and-ashes approach misses part of the story,” he writes.

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