Want to silence a group of colleagues at work or friends at dinner? Heap praise on speculators—and the market bubbles they help create.
Yes, you read that right. Bubbles may be anathema to many financial commentators and ordinary investors. But policymakers like central bankers should applaud speculators and welcome economic booms. And when things head south, they should concentrate their efforts on limiting the damage from the bust.
By this metric, much of the conventional criticism of former Federal Reserve Chairman Alan Greenspan for not preventing bubbles in asset markets like equities and housing from inflating during his tenure is not only misplaced, but wrong.
Up and Up and Up?
Bubble talk is all the rage right now, with prices of commodities soaring into the stratosphere. Case in point: The two-day 13% spike in oil prices last week, to $138.54. Sure, oil has drifted back down a bit, but it's still above $130—vastly higher than the $100 a barrel of last January, let alone the $26 of five years ago. A similar story holds with food and metals.
We've seen this kind of sustained, scary price rise and manic, speculative fever before, haven't we? And we know the outcome, right? The jaw-dropping, wealth-creating boom will end in an awe-inspiring, wealth-destroying bust.
That's what happened with real estate. House prices rose at an inflation-adjusted 4% average annual pace between 1995 and 2005, four times the yearly increase of the previous 10 years. Wall Street and mortgage bankers combined to make enormous sums available to buyers who had gradually been led to believe that a home was a "riskless" investment. Today, the economy is reeling from the bursting of the real estate bubble, and the Fed has felt compelled to take extraordinary actions to stave off financial collapse.
How about Web mania? In the years leading up to the turn of the millennium, dot-com investors thought a price-earnings ratio of 100 was conservative, 1,000 plausible, and infinity conceivable. (O.K., so maybe I'm exaggerating here. A little.) Of course, the dot-com boom turned into the dot-com bust, and the economy tanked in 2000 and 2001.
Men Think in Herds
Bubbles are the most fascinating and frightening stories in finance. The dot-com and housing market bubbles are only the most recent episodes of speculative frenzies, a legendary history that includes debacles such as tulip mania, the South Sea Bubble, the Mississippi Bubble, and the Roaring '20s.
In retrospect, looking at the financial and economic carnage when a bubble goes pop, there's always the puzzle over how so many smart people could be so dumb with their money. Charles Mackay, author of the 19th-century classic Extraordinary Popular Delusions and the Madness of Crowds, captured the essential dynamic. "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
Maybe modern-day oil traders could profit from reading Mackay's book, even though it was published in 1841. Little wonder the commodity price surge has Wall Street on bubble watch and the scholarly literature of the central banking cognoscenti is full of articles on bubblenomics.
Means of Rapid Transformation
Bubble bashers dwell on the bad and ignore the good that speculative price runups can do. Speculative fevers often emerge during times of major innovations and technological change. By definition, the impact of innovation is unpredictable. What new technologies and business models will win out in a competitive market is difficult, if not impossible, to predict. A bubble is capitalism's way of rapidly transforming an economy. It's a perspective Greenspan shared and understood well.