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.
In Pop!, Gross presents a breezy and highly informative history of major U.S. speculative bubbles, seen mainly from the bright side. He argues that bubbles are ultimately beneficial if they create new commercial infrastructures — such as the telegraph, or the railway system, or the Internet — that enable new businesses to grow and old businesses to transform themselves. Crucially, bubbles also create “mental infrastructures,” says Gross, the collective mind-sets that persuade people to change their accustomed ways of doing business — whether sending messages by telegraph, dispatching freight by railroad, or buying and selling via the Internet.
Bubbles, in short, are explosions of entrepreneurial energy that facilitate the rapid rollout and adoption of new technologies. The inevitable excess capacity results in lower prices, making those technologies feasible for general use. Long after the start-up companies have folded and the usual scandals have run their course, the commercial infrastructure remains. Compared with other countries, “we get over bubbles more quickly and do more with what has been left behind,” Gross tells CFO.
Thus, by the time the telegraph bubble finally deflated, the United States was wired coast-to-coast and the cost of telegraphy had dropped to a penny per word. The telegraph liberated value from its geographic confines, says Gross, leading to the creation of national financial markets, stock brokerages (originally known as “wire houses”), Dun & Bradstreet, and the Associated Press. Thomas Edison, Andrew Carnegie, and RCA’s David Sarnoff were all once telegraph operators, he notes.
The inclination to jump in feetfirst and ask questions later is a signature trait of American business, suggests Gross. True, many early telegraph companies were bad investments and investors lost their shirts, while the rollout of the telegraph in Europe was a more orderly affair controlled by the government. But no pain, no gain: by 1852, the United States had strung up more than 23,000 miles of wire. France, in comparison, had a mere 750 miles.
Government as Enabler
This is not to imply that government hasn’t played a key role in America’s bubble dynamic. Gross shows how it has repeatedly helped foment booms — commissioning the first telegraph line in 1843, for example, or granting huge tracts of land to fledgling railway companies, or passing the deregulatory Telecommunications Act of 1996. Without financial, regulatory, and legal help from federal and state governments, America’s bubbles would have trouble getting started.
Meanwhile, the federal government’s response to the 1929 stock-market crash created what Gross lauds as a new financial infrastructure. “It’s difficult to think of anything positive that came of the 1929 stock market crash,” he writes. “[T]he market meltdown and the ensuing long, grisly slide into depression was an unambiguous, searing disaster.” Still, the Securities Act of 1933; the Securities Exchange Act of 1934 and the creation of the Securities and Exchange Commission; the invention of federal bank deposit insurance; the chartering of the Federal National Mortgage Association in 1938; the Investment Company Act of 1940; and more all “laid the groundwork for the remarkable growth of the consumer-driven economy and for the nation’s financial dominance in the second half of the twentieth century,” writes Gross.
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.