Thursday, November 8, 2007

[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -28.5%]

"Bubbles are good. I've made a lot of money on bubbles". Tom Perkins

There is a fascinating debate going on among readers of the Financial Times on the tricky subject of ... financial bubbles [1]. Are they a good or a bad thing? Do central banks have to prick them? Here's my two cents on the controversy: I like bubbles! Here's why. To begin with, there are no financial bubbles in North Korea, Cuba, or the Congo; there were no bubbles in the former Soviet Union either. To the best of my knowledge, nobody has ever heard about a financial bubble in Maoist China. See the point? As the great Canadian economist Reuven Brenner once said (in the midst of the bubble), a bubble gives young entrepreneurs a unique opportunity to experiment with cheap capital. In his recent book Pop! Why Bubbles Are Great For The Economy (New York: HarperCollins, 2007) [webpage] [review], Newsweek blogger Daniel Gross makes an interesting point.

During the mid-XIXth century telegraph mania, says Gross, "Investors lost gobs of money, but the United States soon had the world’s most extensive telegraph system: more than 23,000 miles by 1852, with an additional 10,000 under construction, compared with just 750 miles in France". But the greatest bubble fan of all was none other than Austrian economist Joseph A. Schumpeter. Quoting the great Harvard professor, biographer Thomas McCraw writes: "Financial speculation, though it gets a very bad press, is an important part of this process [of creative destruction]. Speculators often turn out to be investment bankers funding the entrepreneurs who in turn push innovations through the economy" [2]. Ladies and gentlemen: this is precisely what we are witnessing right now.

The trick, of course, is to be long risky assets when "creation" prevails, and short (or long risk-free assets) whenever "destruction" rules. Right now, "destruction" appears to be having a field day: witness the massive writeoffs, to the tune of $60 billion, and the collapse in our Endogenous Liquidity Index. But its reign will be short-lived. Innovation is rampant, and markets will find a way to finance it.

[1] See the relevant "litterature" as published by the Financial Times. Michael Savage: "Medicine may be worse than the asset bubble disease"; George Cooper: "We may have witnessed an old-fashioned monetisation"; Paul DeGraauwe: "Central banks should prick asset bubbles".

[2] Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007, p. 178. [web page] [prologue] [interview] [podcast]


Ross said...

Exactly, think about how wonderfully Japan's equity and land bubbles worked out for them. (/sarcasm)

Bubbles are bad in as much as they reflect poor capital allocation. What you are focused on are the occasional positive externalities of bubbles that either produced infrastructure and capacity that would become productive in time or drove innovation.

Instead, bubbles are also likely to lead to useless excess capacity or useless infrastructure (see again Japan or possibly watch for the deteriorating housing developments in a variety of, especially, coastal US states).

I don't know when one effect sufficiently outweighs the other. But I am willing to bet that, a priori, one could recognize that offering 100% LTV mortgages to people on homes that are 10 plus times their annual household income was not going to bring about benefits greater than costs.

Agustin said...

Ross. "Bubbles are bad in as much as they reflect poor capital allocation". Sure. But what's the alternative? Want to see poor capital allocation on a truly massive scale? All you need to do is to outsource the process to a Politburo-like body. Plus: have you been to Japan recently? For all the equity and land bubbles & crashes, Japan is still one of the world's top economies. Most of its citizens lead a relatively prosperous life. Their problems, IMHO, a more demography- than bubble/crash-related. Cheers.

Anonymous said...

bubbles are great because they result in more trading opportunities. :)

Anonymous said...

What you mean to say of course is that you (and some of your innovative mates) have been enjoying the present prolonged bubble. In other words you are using your 'book' as form of intellectual argument.

You are also suggesting that you cannot enjoy yourself nor make money without the prop of central bank liquidity, no doubt true for yourself but hardly true for the full history of successful businesses and their creators.

There are some successful businesses which grew up in the bubble. Can you name them? where are they now. There are many that grew up before the bubble and after, can you name them. which have performed better? Surely you can provide some factual support for your sentiments? There are many businesses and businessmen who grew up in or were strengthened in recessions and or after bubbles.

I think by implying some wonderful pedigree to the present bubble you are hoping this one will appear well bred.

As to what we are witnessing now? A deflating housing and securitisation bubble.. 'funding the entrepreneurs who in turn push innovations through the economy'?.

These are different animals to those around in the 80s and early 90s, capital was not so cheap nor so abundant but somehow navigated its way to some. But it is obvious you missed out. Quite a few of those years were, in fact, relatively deflated. Certainly in terms of the bubble in self regard.

I am afraid it is a sad indictment (actually a mischaracterisation) if present "animal spirits", "risk taking" and "innovation", must continually be suckled. And I do not think it true. Worse I believe that some of the real innovators in their dotage favour the teat over the weaning.

Quite frankly the fecundity of the teat being the subject of your blog says it all.

Ross said...

Yes, Tokyo is always moving and the vast majority of the world be happy to "suffer" Japan's level of economic malaise.

Perhaps the problem here is the focus on the notion of bubbles. At least in the tech bubble everyone knew that most of the tech firms had no profits and so people knew, or should have known, the risks. But the housing bubble in the US has been aided by imprudent lending standards. A bit of govt effort could have leaned if only by forcing more transparency in the underlying structure of Wall Street's "innovative" asset design.