Bubbles: good and bad

Some bubbles actually do long-term good. The recent housing bubble has no such redeeming feature

Housing prices in some parts of the world have finally fallen prey to gravity. In London, they dropped by 6.8% between mid-November and mid-December, according to a UK property website. Ouch! An average house in upmarket Kensington and Chelsea has become cheaper by around £20,000 over the past few weeks. Home prices in the rest of the UK fell a more modest, but still sharp, 3.2%.


Meanwhile, the US property market continues to slump. In a television interview this week, former US Federal Reserve chairman Alan Greenspan said the government should provide “disaster relief” to US home owners. He seems to be suggesting that the US housing shock is an economic version of Hurricane Katrina.

These are perhaps early signs that the housing bubble has popped—and high time, too. Many expect prices in the US and parts of Europe (and perhaps China) to continue to fall in 2008. In an article in the Financial Times this week, commentator Wolfgang Munchau said: “In the UK the latest upward movement has lasted 10 years and on my calculation prices started to rise above the trend line somewhere between 2000 and 2002. That would suggest that the downturn phase is going to last as long—possibly longer since downward moves often undershoot the trend line. Unless there has been some structural shift, there is going to be one of the most serious housing downturns ever.”

There is inevitable and immediate pain when a bubble goes pop. The journey back to normalcy usually carries with it the extra load of economic slowdown, loss of confidence and a tattered banking system. That’s what the aftermath of several episodes of irrational exuberance in recent years shows—Japan in 1990, Asia in 1997, technology companies in 2001 and the current housing meltdown in the US and Europe. But with the very obvious bad and the ugly, there is also some long-term good that comes out of bubbles. Well, at least some of them.

Take the Internet bubble of the late 1990s. Like all bubbles, it was fed by cheap money. Investors were paying a king’s ransom to buy online companies. Online grocers boasted of higher valuations than large auto companies. A share often cost more than a hundred times a company’s current earnings, which was way above any traditional norm of good investment sense. Some of these online companies had no hope in hell of earning any profits at all. So, they were valued on the basis of wacky parameters such as eyeballs and hits.

As is well known, thousands of Internet and technology companies were charred in the subsequent flame-out. But a lot of good was also left behind. If you are one of those who sifts through the Internet using Google’s search engine, buys air tickets online and downloads music to your iPod, you have to thank not only the scientists and entrepreneurs who were behind these ventures but also the investors who were silly enough to suspend their judgement and fund new ventures, both those that were successful and those that failed.

Or consider the telecom infrastructure mania of those years. What we remember today is the crooked companies such as WorldCom that misled investors. But the $200 billion that was spent in laying cables and other stuff to connect the four corners of the world pushed down telecom costs in the late 1990s. Didn’t that help the Indian outsourcing industry, by making it cheaper to send data across the oceans? The technology bubble had some positive consequences, some intended and some unintended.

In his own work on business cycles, Joseph Schumpeter, the patron economist of Silicon Valley, mentioned the importance of sudden bursts of what he called “wildcat or reckless finance” in fostering innovation. The boom-and-bust cycle in technology in the late 1990s left us with some long-term advantages, both as producers and consumers. In a provocative article in Wired magazine in February 2006, the writer Daniel Gross praises bubbles: “People focus on the sob stories (think of the grandmothers who invested in Pets.com) and the tales of financial chicanery (think WorldCom). But bubbles—those sudden, excessive, and seemingly irrational investment stampedes—aren’t all bad. Sure, they tend to follow a painful cycle of boom, bust, hand wringing, and abject humiliation. But there’s often another step at the end: innovation. Over the past 150 years, many bursting bubbles have paved the way for economic and cultural progress.”

The question is: will any such good come out of the housing cycle? I doubt it. There has been enough reckless finance this time around as well, but it was to fund second homes and excess consumption rather than to support Schumpeterian innovation. Nor has it been used to finance an infrastructure build-up, as in the US in the late 19th century or South-East Asia a hundred years later.

And that’s the big difference.