Are speculative bubbles good for the economy? With much of the developed world still suffering the after-effects of the great housing and credit bubble, it might sound like a trick question. On Friday, however, at the annual conference of the Institute for New Economic Thinking, which is taking place in Toronto, I moderated a session during which several panelists suggested that bubbles can have an important upside: they help finance innovation and growth.
Having spent much of the past twenty years warning about the dangers of speculation, and writing two books about bubbles and their consequences, I felt a bit like Prince Charles presiding at a conference of contemporary architects. Nonetheless, it was an interesting discussion, and I thought it might be worth reviewing some of the arguments that were presented.
If you glance at history, you can’t avoid noticing that the development and application of groundbreaking technologies is often accompanied by froth in the financial markets: it was true of railways, radio, and, of course, the Internet. But aren’t the bubbles just a destructive sideshow, sparked by the desire of investors to get in on the next big thing?
William Janeway, a managing director at the venture-capital firm Warburg Pincus, who is on INET’s board of governors, opened the session by arguing that we need to distinguish between non-productive bubbles, such as the Dutch tulip bubble and the recent housing bubble, and productive ones, such as the tech bubble of the nineteen-nineties. In a world of chronic and irreducible uncertainty about the future—the sort that Frank Knight and John Maynard Keynes wrote about—productive bubbles are about the only way that capitalist societies can mobilize sufficient resources to invest in the technologies of the future, Janeway argued. Although these bubbles inevitably involve a lot of waste, they also bequeath many productive technologies and companies that otherwise would struggle to find financing, he said.
Janeway presented figures showing that, in normal times, venture-capital funds tend to make modest returns, and that they struggle to raise a lot of money. It is only in hot markets that investors are willing to place substantial sums in early-stage investments. He cited Amazon, which, during the dot-com bubble, raised more than two billion dollars before it generated any significant cash flow. A good deal of that money was raised in a convertible bond offering that took place just weeks before the bubble burst.
Steven Fazzari, an economist at Washington University, in St. Louis, cited some research that he did that confirmed the link between access to finance and the amount of research and development that firms, particularly young ones, carry out. When I.P.O.s and new share issues are high, there is more R & D. Since most economists believe that the amount of R & D that takes place is too low, bubbles may be one way, although not necessarily the best way, to address an important market failure, Fazzari argued.
But isn’t most of the stuff that gets financed during bubbles junk? We all remember Webvan and Pets.com. Actually, it isn’t all dreck, Ramana Nanda, of Harvard Business School, argued in his presentation. Citing some findings from a paper that he wrote with Matthew Rhodes-Kropf, Nanda said firms that get funded during bubbles are more likely to fail than those funded during normal periods, but they are also more likely to break out and be major successes. (In other words, the distribution of success is skewed towards both tails.) “It seems that riskier, more novel technologies get financed in hot markets,” Nanda told me. And, he went on, “it is not driven by a bunch of fools rushing in and, simultaneously, the good investors grabbing the best projects. Rather, even the very best investors seem to finance more novel technologies in hot markets.”
Despite its association with periods of speculative excess, many other countries envy the Silicon Valley-Wall Street model of financing innovation. Peter Jungen, a venture capitalist who is also on INET’s board, contrasted the American model to the situation in Europe, where, he said, innovation and entrepreneurship were lacking. If Europe were going to catch up with the United States, it needed to encourage the sort of market-based experimentation that takes place on this side of the Atlantic, Jungen argued.
Few Europeans would argue with that. But how far should the argument in favor of speculation be taken? Ultimately, it doesn’t seem persuasive to argue that important technologies can’t be financed without bubbles. Automobiles, televisions, and personal computers were all developed without the assistance of a full-scale bubble. So were countless other innovative products. There is also an important policy issue. If bubbles are good, shouldn’t we encourage them, or at least tacitly endorse them?
Alan Greenspan, when he was the chairman of the Fed, argued that it wasn’t the central bank’s role to pop bubbles. A better policy, he said, was to let bubbles burst on their own and concentrate on minimizing the fallout. Janeway, the author of the 2012 book “Doing Capitalism in the Innovation Economy,” said that he didn’t wholly agree with Greenspan’s non-interventionist approach. Because of bubbles’ self-reinforcing nature, they tend to get so big that, at some point. the Fed doesn’t have any choice but to step in, Janeway said. But he also argued that a bubble doesn’t have to be followed by deep recession, particularly if it is confined to the stock market rather than the credit market.
The obvious trouble with this argument is that, once the authorities start down Greenspan’s road, they find it very hard to turn back. Yes, the recession of 2000 to 2001 was a mild one. But that was partly because, after the Nasdaq collapsed, the Fed slashed interest rates and flooded the markets with liquidity. In subsequent years, when capital investment and hiring remained weak, the Fed was driven to keep interest rates artificially low, and this easy-money policy played an important role in inflating the housing and credit bubbles. If you accept this analysis, the ultimate consequence of tolerating bubbles was ruinous. According to a study by the Dallas Federal Reserve, the cost of the Great Recession was somewhere between forty per cent and ninety per cent of 2007 G.D.P.
That’s not to dismiss the great success of some of the companies founded during the tech bubble, such as Amazon and eBay. Similarly, some of the investments in the dot-com era that seemed to be wasted, such as the laying of large amounts of fibre-optic cable, turned out to be productive. Is there a way to encourage the investment and innovation we want without enduring all the consequences of a bubble?
Fazzari said that we need to confront the structural problems that bubbles address, perhaps by raising public spending on research and development, or by encouraging public-private partnerships. Janeway and Jungen agreed that more public investment in science and technology was needed, but they were skeptical of official efforts to pick winners. Still, everybody on the panel agreed that the government can play a useful role by supporting basic research and buying products that embody new technologies. After all, that is what the Department of Defense did during the development of the Internet.
That leaves open the question of whether we also need occasional bubbles. I’m still not convinced. But in an era when a lot of people are once again talking about the threat of secular stagnation, it’s a question that will come back.
Photograph by Yagi Studio/Getty.
