By Bradford DeLong, Professor of Economics at U.C. Berkeley
Conventional wisdom says that bubbles in asset markets are dangerous and destructive: sources of waste, chaos, loss, and unhappiness. And it is indeed the case that the unwinding of a bubble is a time of danger, and a potential cause of economic distress. Those businesses that were financed by the bubble close down, and their workers' jobs disappear. The hope is that other, alternative leading sectors of the economy are growing up at the same time in order to replace the demand and provide the jobs that had existed in the bubble-prone sectors. And the economic management task of trying to make the sectoral shift takes place fast enough to avoid a severe depression, yet not so prematurely as to destabilize the price level and invite rapid inflation, is a very difficult one.
But suppose that the process of unwinding the consequences of an asset market bubble is carried out successfully. What then should be our judgment of the bubble itself -- the wave of enthusiasm, the eager bursts of entrepreneurship, the build-out of enterprise and capital that ended in losses, tears and distress?
The conventional wisdom after the fact is almost invariably that the bubble was a bad thing -- bad for investors, bad for workers, bad for producers and bad for consumers. The prophets of change are, after the fact, scorned. And the arguments that first made investing in bubble-driven assets seem a smart play are dismissed as things that were always false and always obviously false. So was the case with the American high-tech dot-com stock market bubble of the 1990s. When expectations and the bubble collapsed, the consensus rapidly became that the entire "new economy" complex had been a bad idea and had always been a bad idea -- that time, talent and capital had been thrown away on unsustainable and unproductive enterprises, and that America was a lot poorer as a result.
But is this true? It is certainly the case that in the late 1990s fortunes were poured into overflowing snake pits built out fiber-optic cables and establishing webs for online businesses, which in the end proved to be zones completely free from profits or indeed even the return of capital to investors. It is certainly true that ＄800 billion more was invested in the five short years that ended the 1990s than was ever returned to investors. But it is also true that the enterprises financed by all the dot-com IPOs wound up paying for a massive build-out of the public internet infrastructure that all Americans could then use. The burn rate of the internet companies was ferocious, but they left behind much more than ashes. As Intel cofounder Andrew Grove said in the pages of Wired magazine, "The dot-coms threw themselves onto the bonfire, but they created a bigger flame as a result." Companies like Microsoft, Dell, and Intel itself found their market values greatly diminished. But the products that they made proved to be of substantial value to consumers.
In the long run -- in fact, already -- economists will look back and see substantial value and social benefit generated by the dot-com boom of the late 1990s. Just because a group of firms, an industry segment, failed to succeed as a set of profit-making enterprises for their investors, does not mean that they failed as a productive enterprise for society at large. In a market economic system, the profit motive is useful primarily because it signals the proper and appropriate sizes of a set of enterprises. If enterprises are too small, then it is likely that customers will be desperately in need of what they make, that prices will be high, and that profits will be correspondingly large. And it is the prospect of even larger profits through expansion of scale that induces investment and the growth of enterprises. Conversely, if a set of enterprises happens to be operating at too large a scale, then customers will be close to sated, as a result prices will be relatively low, and profits will be lacking.
Thus if profits are high, the industry segment should grow; if absent, it should shrink. Profits (more generally, value) teach us whether the enterprises should grow or shrink at the margin. They do not tell us about the worthwhileness or total utility created by the enterprises. This is similar to the diamonds and water paradox that so exercised the classical economists 200 years ago: in wet, rain-soaked Britain in 1800, water was free and diamonds were expensive, yet water was necessary and diamonds were a trivial luxury.
That the dotcom and telecom sectors needed to shrink in the U.S. in 2000 told us next to nothing about how useful their products were. The US airline industry is a perennial loss generator. Yet the service it provides the rest of us is incredibly valuable. British investors in US railroads during the late 19th century got their pockets picked twice: first as waves of over enthusiasm led to overbuilding, ruinous competition and unbelievable (for that time) burn rates. The second came as sharp financial operators stripped investors of control and ownership during bankruptcy workouts. Yet Americans and the American economy benefited enormously from the resulting network of railroad tracks that stretched from sea to shining sea. For a curious thing happened as railroad bankruptcies and price wars put steady downward pressure on shipping prices and slashed rail freight and passenger rates across the country: New industries sprang up.
Consider, for example, the old Montgomery Ward and Sears Roebuck catalogs. Sears and Montgomery Ward discovered at the end of the 19th century that the cost of shipping consumer goods to rural America was no longer a competitive burden. Mail a catalog to every household in America. Offer them big-city goods at near big-city discounts. Rake in the money from satisfied customers. For two generations this business model -- call it the "railroad services" business model -- was a license to print money, made possible only by the gross overbuilding of railroads, the resulting collapse of freight rates, and the fact that railroad investors had had to kiss nearly all their money good-bye. Their pain was outweighed by the gain to American consumers and manufacturers, who could now order and ship goods essentially free. The irrational exuberance of the late 1800s made the railroads a money-losing industry -- and a wealth-creating industry. The more money investors lost through overbuilding, the lower freight rates became, and the more railroads belched out wealth for everybody else.
The same thing happened with the froth that the bubble put on America's 1990s boom. Investors lost their money. We now get to use all their stuff. What got built wasn't profitable, but a large chunk of it will be very useful.
This is the lesson of the late 1990s bubble. And five years from now we will draw similar lessons about America's recent housing bubble.
First of all, subprime borrowers who put no money down and so have no equity and live in non-recourse states have done rather well over the past five years. They have gotten really cheap rent for several years, and now can decide whether to renegotiate or move. Their housing costs have been for half a decade subsidized by investors in subprime -- who are in general much better off than are the borrowers and it is hard to argue that the transfer from investors to marginal borrowers is a bad thing.
Second, during the early 2000s the global economy did have a global investment shortfall. The surge in the profit share in the U.S. made manufacturing, transportation, and distribution businesses much less dependent on flows from the credit markets for their capital-expansion funds. And in the extraordinary surge in capital inflows coming from foreign central banks, and investing the resulting funds in housing does not seem like a major waste of resources.
Third, we have learned a valuable lesson about the vulnerability of modern high-tech finance to misrepresentation and misguided incentives. It is not that there is anything especially new about financial innovation making it too easy for investors to buy complex securities they didn't fully understand -- the Bardi and the Peruzzi families did so back in the fourteenth century when they loaned money to Edward III so that he could launch the Hundred Years War against France. To the extent that this crisis does not lead to a depression, America is in better shape understanding this vulnerability than it was three years ago.
Fourth, America now has an extra four million houses, houses that people can live and raise their families in. Since 2000, four million extra new homes have been built over and above those that would have been built if things had followed long-run trends. Those extra houses are currently occupied by the 3 million American households that were priced out of the pre-bubble housing market. But were the lenders to foreclose on those houses, they would then find themselves trying to sell to four million other households that are even less-rich and less-credit worthy. So the best strategy is for the lenders to sit down and negotiate. The lenders lose as they renegotiate. The borrowers gain. But the net losses are small.
Only if the current financial crisis leads to a depression will the overall social balance from the 2000s housing boom be in the red.