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The Bright Side of Bubbles

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

Today, Gross sees a bubble, or at least “half a bubble,” beginning to form in alternative energy. The most visible evidence is ethanol production, heavily subsidized by the federal government and protected by a tariff on sugar-based ethanol. Plenty of venture capital is flowing to solar and wind energy, too. State governments are offering tax credits and other incentives for investments in alternative fuels and solar panels. As during previous bubbles, a cultural mind shift is taking place: environmentalism is hot and companies routinely talk about going green. The same exuberant predictions of new eras and wealth creation that marked previous bubbles are heard.

But don’t get Gross wrong: he thinks a bubble in alternative energy needs to grow, not subside. Only a typically American boom and bust can do the job of making the U.S. economy radically less energy-intense and less dependent on global-warming fuels, he says.

So what is the silver lining of the housing bubble, according to Gross? For starters, it kept economic growth going, creating many new jobs. The bubble updated America’s housing stock and stimulated the development and renewal of neglected urban areas, such as the South Bronx. It encouraged some to migrate from crowded, overpriced coastal areas to cheaper, more spacious homes in less populated parts of the country. And it made people generally more knowledgeable about home and personal finance as they shopped for better interest rates and refinanced their mortgages. (These days, many who obtained adjustable-rate or subprime mortgages are perhaps better described as sadder but wiser.)

But if past is precedent, it will take much longer to see what new commercial infrastructure the housing bubble will create. Gross speculates one result could be a spreading, or socialization, of risk — something like home-equity insurance, for example, which would protect owners against housing downturns in local markets.

Countering the Contrarian

The United States remains the world’s largest, most robust economy, and it has absorbed serious shocks before. So it’s not surprising that some people remain relatively sanguine about the rise in housing prices. But a look back at Japan’s “lost decade” of the 1990s could change their minds, suggests Franklin Allen, a professor of finance and economics at the Wharton School. A co-author of Brealey & Myers’s standard textbook Principles of Corporate Finance, Allen’s latest book, written with Douglas Gale, is called Understanding Financial Crises (Oxford University Press, 2007).

Allen thinks that bubbles do exist; “there are situations where asset prices have gotten so high that there’s no reasonable explanation that is consistent with anything other than a bubble,” he says. Take Japan, where the bubble in the stock and real estate markets that popped in 1990 led to well over 10 years of steadily declining real estate values. Today, land and residential prices are still far below their peak. The Japanese economy didn’t suffer huge unemployment, but the banking system was “devastated,” says Allen, “and the growth rate collapsed.” By one reckoning, the difference between potential gross domestic product and actual GDP between 1992 and 1998 was a staggering ¥340 trillion.

But the case of Japan is admittedly an extreme one, and surely nothing remotely like that can happen here. Or can it?

Edward Teach is articles editor of CFO.

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