Economic Man Versus Political Man

The return of Che Guevara’s body to Cuba after 30 years in an unmarked Bolivian grave represents a symbolic end to the Cold War. Che embodied the ideology of the Communists and Socialists who believed that a society could be created on political structures alone. He raged and fought against what he saw as the violence perpetrated by the Capitalist system and its practitioners against the innocent and powerless. He believed passionately that a new society could be created in which each citizen put the good of the society first and worked toward the ultimate goal of a fair society and practiced this personally. He also believed that the ends justified whatever means it took to get there – and practiced this as well. In the end he died for these beliefs, but, more sadly, in the final analysis he was proven wrong.
A society cannot be built on political structures alone. This belief stems from the view that the basis for all human actions is political in nature. If politics is the foundation on which human behavior is based, then that behavior is susceptible to political manipulation. By creating the proper set of political structures it should be possible to shape whatever society desired. One sees the consequences of this thinking all too well in the recent histories of the Communist countries. It is especially evident in their failure.
They failed because there is another set of fundamental laws that affect human behavior – economics. Economics are a more basic and influential motivation for human behavior than politics and cannot be ignored. The Communist countries tried for 70 years to ignore economic laws and in the end those forces rose up to defeat them. The forces of economics triumphed because in the end they provide the means to operate society and if they are constrained too tightly for too long, the society will collapse upon itself as shortages arise. Political structures can dominate for short periods of time, but if they remain in place too long they eventually give way to the underlying economic forces.
The proponents of unfettered economic forces, i.e. laissez faire Capitalism, should not smile in smug satisfaction at the triumph of their ideology, however. The periods of unbridled dominance by economic forces have not been any more successful than those of political hegemony. Unshackled economic forces have brought us the Robber Barons, the Great Depression, the 1980s financial crisis, and other ills as the pursuit of economic supremacy inevitably lead to a division of the wealth of the population. The number of losers has always been greater than the winners and eventually lead to a political reaction that once again subsumed the economic forces to political power. Ascendant economic power has the effect of strengthening the political forces to serve as a counterbalance.
In the end the fight does not boil down to Capitalism versus Communism or Socialism or any other ism, but to economic man versus political man. The ideological labels merely serve to hide the essential drama of the human striving for success and to misdirect energies into needless ideological warfare. The battle is between whether political man should be ascendant or economic man. The other dramas are merely different manifestations of the same reality, clothed in ideological garb.
Playing politics tends to be the first choice of many, especially the have-nots, because it is much easier, faster, and enjoyable than playing economics. It also may not require much capital to engage in. Economics is hard work, takes a long time, and has deferred rewards. Generally, some amount of capital is required as well. It is far easier to impose a political solution on a problem than it is to work on the underlying economic factors. These quick fixes don’t last, however, and eventually are replaced by harsh economic-based solutions. These solutions tend to underinvest in the people left on the sidelines and lead to political turmoil. A society that does not invest adequately in its people cannot long endure economically.
The economics vs. politics tug-of-war can be seen on smaller stages than the world. It also influences smaller events and policies. A recent example was the fight over welfare reform. Those with a political bent pushed for an expansion of the current, universally acknowledged failed, system arguing that it failed by not going far enough, while those tending to economic solutions wanted to virtually eliminate it. The debate raged between the “Here’s a check, have a nice day” crowd and the “GET A JOB!” fans. The choices were clear and mutually exclusive. In the end a compromise was struck, but the debate aptly illustrates the two approaches, their benefits, and their drawbacks.
What to do if you cannot count on one approach yielding the desired long-term goal of a stable, growing society? As in so many things, somewhere in between the extremes is best. The proper mix should be skewed towards the economic end of the spectrum because those forces are more fundamental and yield the growth engine for any society, but political structures to address the shortcomings of a wide open economy must be created. It can be argued that this will reduce the overall efficiency of the system, siphoning off resources to “non-productive” ends, but in the long-run the society will be better off socially and even materially. The society can grow more smoothly and continuously without periods of political turmoil and reversals of direction. For it is not the degree of free reign given to an economy that will determine its efficiency, any economy will eventually determine the most efficient allocation of resources within a given set of parameters, it is the consistency and duration with which those parameters are applied. Constant tinkering or wholesale changes are greater dangers than applying some proscriptions to the economy. It is important that the restrictions are not too burdensome, but it is just as important that they are there.
It is time for our leaders, especially governmental leaders, to stop playing politics and start playing economics – in its most positive sense. Solutions to problems need to be looked at as to the economic costs and benefits, short- and long-term, for each approach and the best solutions followed to its logical outcome – which may be at odds with one’s ideological view. The solution to poverty is free markets and investment in poor communities, but can that really succeed without accompanying programs to help the poor become trained, care for their children while at work, or even just get to work? Is the answer to crime simply more prisons or programs to address the root problems? Too often we are offered half a loaf – just free markets or just social programs. Both are required to be successful. We need to recognize these competing forces in our society and how they have influenced the outcomes of our programs, and to recognize that economic man must work with political man to jointly build a better world.

Capitalism, More Or Less

Capitalism, More or Less

Prime Minister Tony Blair of England, at the recent World Economic Forum in Davos, Switzerland, reiterated his call for a “Third Way” between Capitalism and Socialism/Communism. His aim, and that of German Chancellor Gerhard Schroeder and even US President Bill Clinton, to a lesser degree, is to find an economic model that is as productive as laissez faire Capitalism yet provides for those who suffer from Capitalism’s “excesses.” It is an appealing argument and one that is embraced by many who fear the power of unbridled Capitalism and the totalitarian aspects of Socialism. They feel that there must be a better system because they reject all the others. The focus now is primarily on displacing Capitalism since Socialism has been thoroughly discredited for the moment and Capitalism is ascendant. The degree of fear concerning Capitalism was clearly evident at the recent World Trade Organization meeting in Seattle. What form a Third Way would take has not yet been defined, but the search is on.
Unfortunately, it is not likely to ever be defined, since no Third Way exists. For that matter, no Second Way exists, either. In reality, only one economic system exists, encompassing the fundamental laws of economics, which for want of a better word I’ll refer to as Capitalism. All other economic models exist only as a negation of certain features of the Capitalist model. There are no fundamental economic laws that underlie Socialism, Communism, Third Way, Feudalism, or any other economic system that has been tried, such as support Capitalism. These other systems are predicated on the negation of one or more principles of the Capitalist model, and not on any laws of their own. They are constructs, also, of additional precepts that are created to make the systems work rather than form their foundations. It is as if someone is trying to replace Economics with a second kind of economics as some try to replace Science with creation science. They are trying to replace the invisible hand of the market with the invisible hand of God. Or the all too visible hand of man. There is only more Capitalism or less Capitalism, not anti-Capitalism.
The fundamental laws underpinning Capitalism are not numerous in any case. Once past Supply and Demand, Marginal Cost, and a few other laws, the principles that underlie Capitalism are largely expressions of these fundamental laws and not laws in themselves, as so often seems to be assumed. Some of the problems with how Capitalism impacts society stems from the mistaken view that observed relationships somehow constitute a “law” of economics, such as the Phillips Curve, and not an expression of the underlying fundamental laws. Relationships among economic factors are mistaken for “truth” and policies are based on those perceived truths when in fact these “laws” will change as relationships and economic factors change. This approach too often narrows policy choices unnecessarily and precludes actions that might be more sound economically and more acceptable socially. As in science, it is best to reduce theories and laws to their most basic levels, but it seems sometimes as if economists are intent on creating a superstructure rather than a foundation.
Economic theory tells us that an economy will move to the most efficient allocation of resources with a given set of resources and parameters, such as legal and social structures. This is often misconstrued as the most efficient economy is the one with the least restrictions, when any set of parameters will, given time, lead to an efficient economy, given those parameters. The economy will move toward equilibrium and tend to stay there in the absence of any significant exogenous or endogenous changes. We are today witnessing the results of such a scenario as the stable monetary and fiscal policies of the last few years, combined with relatively minor changes in resources and interrelationships, have allowed the US economy to move toward its most efficient allocation given the current parameters. A stable tax system, prudent monetary policy, controlled government spending, and relatively smooth commodity price changes have given us one of the best economies of our history. Milton Friedman’s call for a computer to replace the Federal Reserve may not be that far off the mark. Even the various economic crises of the past few years have had muted effects because of prudent responses to those crises. A major tax cut, significant interest rate change, or massive spending increase will throw this system into disequilibrium and lead not to prosperity, but to a recession.
To say that there is only Capitalism does not mean that we are condemned to the impersonal, unfeeling marketplace. To a world where only the strong survive and the weak suffer as is their due. Unfettered Capitalism is only maximally efficient in a closed system. When circumstances change or externalities such as pollution become problems, Capitalism has a difficult time addressing these matters. Laissez faire Capitalism also has trouble moving to the next level. It underinvests in areas such as education, infrastructure, and research that are needed to transform an economy. Eventually the investments will be made, but at a pace far too slow and in a manner that does not benefit the losers from the last level.
This flaw is only becoming more evident as the complexity of our economy increases. No longer is there such a dichotomy between capital and labor since a large portion of capital is now resident in people’s minds and not just machinery. The old tradeoff between capital and labor as competing, interchangeable factors becomes increasingly complex as labor becomes more heterogeneous. In a world where what people know is the critical variable in determining success, investment in this area is vital to keep an economy moving forward. If there is not sufficient investment in this area, then that economy will not achieve its potential and fall behind other economies that are investing in education.
This holds true as well in the other areas of the economy that are slow to be invested in. Choices must be made to invest in these areas to keep the economy growing. Choices incur costs, however, and there should be no illusion that choices made in these areas will have costs. That, however, is the hang-up that many free marketers have in making the decisions to intervene. To a free marketer, any restriction distorts the most efficient allocation of resources so they must be eliminated. They prefer minimal intervention to allow the market to work. That will work, but the associated costs may be more than a society wishes to bear. Under this view, only a complete, unfettered economy will be truly efficient. The reality is that some restrictions are necessary to raise us beyond the survival of the fittest and, given time, will result in an “efficient” economy. It is arguable that such restrictions may result in a more rather than a less productive economy than a completely free one.
This is where choice becomes paramount. A society needs to choose what kind of economy it wishes to have and how it will get there. The choices must be made with conscious deliberation and a recognition of the costs these choices involve. A choice between greater social welfare and rugged individualism can be made, but with respect to the costs associated with each. The greater the degree of intervention, the greater the costs and the fewer the benefits. There may be an optimal amount of intervention that has initially greater benefits than costs, but where that is has to be closely examined.
Other forms of economy, then, are political constructs rather than economic models based on fundamental economic principles. We need to understand that, in order to achieve the type of world we seek, choices must be made, tradeoffs have to be accepted, and it takes time to accomplish. There is no mythical Third Way to run an economy because there are no foundations on which to build such a structure. There is no kinder, gentler economic system that will cure the world’s ills. As distasteful to many as it may be, we are forced to work within the Capitalist framework to develop our economy. There are choices that can be made within that framework, but they should be made consciously and in full recognition of the costs and benefits. Otherwise we get a system of haphazard construction and one less than fully endorsed by the whole society. Asian economies did very well the past few decades because everyone accepted the structures set up and they were able to close off their economies to a large degree. They are doing less well now as interests have diverged and there are conflicting demands on those economies. They are also less protected from the outside system that was more Capitalist. They need to once again build a consensus to get their economies back on track.
We do not need to copy their model, it would not work in any case, but we do need to make a more deliberate effort to define the economy we wish to have and to set forth the path to accomplish that goal. We are no longer fighting over ideology – Capitalism versus Communism – but over how best to reach our goals within the Capitalist framework. If we do not, we will continue to fall short of our potential and increase the level of dissension among those not benefiting. It is especially critical to do so now as the world moves ever closer to the pure form of Capitalism and those affected by the change increase.

BRAVE NEW WORLD OR DÉJÀ VU?

BRAVE NEW WORLD OR DÉJÀ VU?

In the past several weeks Bridge News has presented two views on the current state of our economy and whether it is the same as it has always been or is somehow different. David H. Resler of Nomura Securities, in his opinion piece of July 14, argued that the current economy more closely resembles that of neo-Classical economic theory than the neo-Keynesian framework we have used for several decades. He feels neo-Classical economic theory will now be more useful in examining the economy and of greater predictive value than the neo-Keynesian model. Federal Reserve Board Chairman Alan Greenspan, in his testimony before Congress, stated that it was too soon to know whether or not the U.S. economy has entered a different economic era. One where the old strictures and rules might no longer be relevant and which allows the U.S. economy to grow faster with less risk of inflation. He stated the Fed is still examining the issue, but it is clear from the recent behavior of the Fed that they are seriously considering that such may be the case.
Theirs is an attempt to define a structure; a new world-view that can explain the current state of affairs and that can be utilized in an analytical framework because the current models do not appear to be working. Given their position this is understandable – the future of Nomura’s position rides on Resler’s shoulders and, literally, the future of the world’s economy rests on Greenspan’s. Each needs to develop an understandable model of the economy that is useful for prediction and, by extension, decision-making.
The question arises, “Are they following a prudent course or are they falling short of what is needed to understand the current economy?” Are they unnecessarily limiting their outlook and straightjacketing their policy responses? The problem with their thinking is that neo-Classical, neo-Keynesian, or any other theoretical constructs are more descriptive than prescriptive. They are more capable of telling us where we are than of how we can get to where we want to go. They can tell us how to maintain the status quo, but not how to create a more desired outcome.
Both Resler and Greenspan appear to be looking at the trees and missing the forest. The question is not whether things are different, of course they are, but what does it mean to say they are different? Are there different sets of economic laws that govern our economy at different times or do just the circumstances change? The laws of economics, like those of physics, are immutable. The Law of Supply and Demand today follows the same principles it did since time immemorial. Economic laws do not change from one era to another, but remain timeless. What do change are the relationships among the various components that make up an economy and thus its outcome. Understanding these changing relationships is crucial to developing an accurate picture of how a complex system operates. A metaphor might be useful as an explanation.
Imagine our solar system, where the movements and locations of the various heavenly bodies are determined by the laws of planetary movement, gravity, and other physics principles. In the absence of an event that disrupts the system, it will remain essentially in stasis. Now imagine that Jupiter breaks into 15 different pieces that are scattered throughout the solar system by the force of its disintegration. Depending on the ripple effects of the changes induced, the solar system may change only slightly or be radically transformed. What changed were the relationships among the system components. Each now has a different constellation of forces affecting it, but the immutable laws of physics govern the reactions. The laws governing the system have not changed, but the system surely has. Whatever the outcome, it will be determined by physical law and not the actions of the components. The laws of physics allow us to understand the changes and to predict future events.
It appears that our economy is in a similar state of flux following the monumental changes in the world in the last decade. The world has gone from a Cold War with the globe divided into blocs of self-contained economies to one where the barriers have largely disappeared. The ongoing technological and informational revolutions are also changing fundamental relationships. What has not changed are the economic laws underlying the international economy. The changes observed are the result of the changing relationships among the nations of the world, the means of production, and the access to information. The outcome is shaped by the changing relationships, but determined by the laws of economics. The changes are ongoing and far-reaching and it is by no means certain that we have seen the final shape our international economy will take. In fact, it is more likely that we will see major changes continue for a long time to come.
And, since the relationships between components change through interaction, answers found today may be incorrect tomorrow. Why is M2 no longer a useful policy tool? Is full employment 6%, 5.5%, or some other number? The answer depends on what other things are happening. China’s opening to the world has added a billion new workers to the international labor force and India may soon add its near billion. That has helped hold down potential wage growth, lowering the full-employment level, but what happens when one billion Chinese decide to become mass consumers? What happens to the rosy inflation outlook then? In such a situation we must reexamine all of the “truths” which we have established on the economy to see if they still hold. The difficulty lies in the fact that many have not yet grasped just how much change has occurred as these relationships shift and how necessary it has become to reevaluate their analytical constructs. The changes have not yet been included in their world-view and thus their outlook remains incomplete at best and seriously skewed at worst.
Because the international economy is in such a state of flux, it makes the attempt by Resler and Greenspan to pigeonhole the economy all the more Sysiphean. What they are attempting to do is necessary for their purposes and responsibilities, but if it does not remain a dynamic process, over time their theoretical constructs will be too restrictive and lead to incorrect decisions. They will end up constantly making ad hoc adjustments to their models or searching for new ones to account for the continuing changes. Far more than in times past, what is needed now is a flexible approach and a willingness to realize the economy is changing – yet staying the same.

ASSET BUBBLES AND BUNGEE CORDS

ASSET BUBBLES AND BUNGEE CORDS

THE SEARCH FOR A BUNGEE CORD MONETARY POLICY


U.S. Federal Reserve Chairman Alan Greenspan has defended the Fed’s actions concerning the Nasdaq price bubble, largely on the basis that to fight the bubble would have required the Fed to send the economy into a major recession. The benefits, if any, of pricking the bubble did not appear to outweigh the costs involved and thus no action was taken. In any case, it was not even clear if there were a bubble. Without such a determination, policy prescriptions are not clear and the danger of economic calamity from incorrect action increases. Under this scenario it made little difference whether the recession came from a burst bubble or Fed policies.
There has been debate as well between the efficient market adherents and the behavioralist wing in economics as to whether this was a rational or irrational event. An examination of the situation shows both Greenspan and the efficient marketers to be correct, although a fuller explanation is required.
There are several aspects to this review. The first is that identification of a bubble is difficult, mostly accomplished in ex poste fashion by witnessing the collapse. How best to deal with them is even less clear since they are so hard to identify. It may be that there are different kinds of asset bubbles, rational and irrational, and that they require different policy approaches to deal with them. It may also be that asset bubbles only become bubbles when they are perceived as such and actions are taken in regard to this perception. They may not be a problem until they are a problem or turned into a problem. Finally, the wisdom of mitigating the impact of asset bubbles and the responses by policy makers need to be fully examined. The proposed response by many observers amounts mostly to a let them have their cake and eat it, too, approach. Let’s have bubbles, but let’s find a way to mitigate the fallout.
Identification of an asset bubble is very difficult, even after the fact. The real question seems to be not so much whether there is an asset bubble, but whether such a bubble holds the possibility of large, negative consequences when it bursts. That determination seems to be dependent upon whether the bubble is viewed as having a rational or irrational basis. Asset bubbles that are viewed as having a rational reason for their existence are viewed as less likely to cause massive dislocations outside the particular economic sector in which they grow when they finally burst. Inside the sector there will be significant fallout, but it will not threaten the stability of the financial system. Asset bubbles that appeared less rational in nature or which infect large areas outside the initial sector are considered far less benignly. Their potential for disruption is greater and more likely to affect many areas of an economy. Such a widespread collapse would engender financial instability and threaten the well-being of the economy.
Rational asset bubbles may best be seen as adventures in valuation pricing, an attempt to place a value on an asset for which there is little historical background. Asset bubbles associated with new technologies may be the best examples of these rational bubbles. In the initial excitement over the promise of new technologies, such as railroads, telephones, or internet, investors may include all benefits from the technology in the prices they are willing to pay and not just those benefits which will accrue to a given investment or stock. The initial price euphoria captures the benefits from externalities as well as the specific benefits that will be given to an investment. Investments as a class are even more likely to reflect this global pricing and become overvalued on the basis of the benefits rightfully flowing from the investments themselves. Since investors are unsure which stocks will benefit in the long run, all get bid up.
Once investors become convinced that the investments will be unable to attain the full benefits implied by the global pricing, the prices collapse and often do not return to the same levels again for a long time, if ever. It is tempting to view these asset bubbles as irrational, and many have done so, but it is more correct to view them as the initial stage in the valuation of a new technology and the initial pricing as rationally including all perceived benefits flowing from that technology. The prices are accurate in that they fully account for the whole potential of societal impact from the new technology. The desire to capture future benefits leads to overinvestment, or more precisely premature investment. Investors see the future stream of benefits, but not always the difficulties in making them a reality. (The same mechanism may be at work when markets overshoot on the upside as well as the downside. Investors overshoot on the upside when trying to price in all the good news by generally bidding up all assets and overshoot on the downside trying to accommodate the bad news by generally bidding down all assets. This will hold true for all levels of the market down to and including individual stocks.)
The roller coaster ride that was Nasdaq is a perfect example of this phenomenon. The euphoria surrounding these stocks built gradually and compounded on itself as the potential of the new technology became more apparent. To be sure, there were other factors for a given stock, such as speculation or day-trading, but as a whole the rise was driven by the vision of the future. The ways in which many of these companies accounted for their futures on their balance sheets reflected this view as well. Once it became clear the future was a long way off and that reaping the profits would be difficult, investors took a closer look. At that point, investors began to question assumptions about future sales and profits and how they were accounted for and the ability of some companies even to survive. Much of this reflection occurred as these companies came back to the markets for a second round of financing and it became clear that they would burn through this capital as well with little to show for the investment. Once the foundations for the prices were eroded, the pyramid collapsed. It is unclear if these prices will ever return to their peak levels.
Asset bubbles that do not stem from new technology are more likely to exhibit irrational pricing behavior and to affect the pricing of other asset classes. The collapse of such a bubble will have more far-reaching negative impacts as a result and tend to cause instability in the financial system. Asset prices in this case do not reflect the global return for an asset, but a belief that the price of the asset will continue to go higher and higher with any price fall in the distant future or of negligible amount. Such bubbles tend to drive up the prices of other asset sectors to raise their return to compete with the now relatively higher returns in the bubble sector. A generalized rise in asset prices results and the collapse of the bubble tends to take all other prices down as well.
The recent rise in Japanese stock and land prices is a good example. Stock prices in Japan rose continually on the view that Japan’s economy was headed for the moon, which in turn caused real estate prices in Japan to follow suit. The bubble was compounded by the use of stocks and real estate as collateral to buy each other, pyramiding the growth in prices to unheard of heights. Capital expenditures financed by the proceeds reinforced the feeling of Japan’s economic invincibility and fed even higher prices. To make matters worse, the asset bubble in Japan spilled over into other regions and into other asset classes such as art and precious stones. Japanese buyers pushed up real estate prices in many foreign countries for both commercial properties and homes, while the Japanese love for art and jewelry led to buying binges in these areas. The collapse of the Japanese Bubble starting in 1990 had an effect in these sectors as well. The Japanese bubble had far-reaching and destabilizing effects that mark it as irrational in nature. (It is conceivable that the bubble could be viewed as pricing in Japan’s future prosperity, but the widespread impact of the bubble outweighs this.)
Another factor that may be at play here, too, is that markets may be asymmetrical in their ability to handle surplus versus scarcity. Markets appear to work quite well when there is scarcity by allocating resources to the investments with the highest returns. It is usually quite clear what these investments are so that the markets allocate the available resources quite efficiently. Such may not be the case when there is a surplus of resources, as we have recently experienced. The available return on investments falls as those with the highest return are invested in first and the ones available have a lower rate of return. Complicating this is that the number of investments at a given level of return rises as the return is lowered, making allocation a more difficult task. Given sufficiently low enough returns, it becomes even less certain which ones are the most desirable to invest in since it is hard to predict actual versus expected returns. This may cause long-term difficulties in an expansion and lead to its collapse.
Investors may then have several reactions. They could invest in all available investments driving up prices across the board since it does not matter which ones are chosen. They could be indiscriminate about which particular ones they invest in since it is unclear which ones will yield the highest return, driving certain assets that become popular to astronomical heights. They may eschew investing in investments with a low return since they are not certain which ones are best and over-invest instead in those areas that have shown a high return. This drives these asset prices far higher and creates an over-investment in capacity in that sector. The root cause in each case is that a surplus causes a change in investment behavior due to the difficulties in identifying the best investments that is not seen in times of deficit.
This reaction raises the question of whether investors invest to maximize return or to receive a given rate of return. The answer may depend on the prevailing circumstances. Low interest rates and a booming economy, such as in the 1990s, may push investors to pursue maximizing returns, which means that they also maximize risk. Investment is distorted and the economy eventually slows. High interest rates in a slow economy may lead to investors setting a given rate of return as their goal since only high return investments can be profitable, but the high risk may be too much in a slowdown. This will lead to underinvestment and keep the economy slow. Low interest rates in a slow economy will likely yield the best allocation of resources with investors seeking to put money into projects that exceed a certain return, while high rates in a booming economy will tend to move investment to the highest uses only.
Even with so obvious an asset bubble as the one in 1980s Japan, however, the question remains what should be done about them, what role is there for monetary authorities in addressing them? Even more to the point, should anything proactive be done or should action be confined to ameliorating the effects of the collapse? While one can easily see the rationale for considering irrational asset bubbles a menace, it is not so clear why a rational bubble escapes this view. Granted, the scale of the collapse is generally smaller and narrower and, therefore, less of a threat, but that does not provide a basis for examining which bubbles should be left alone and which should attract more attention. There is substantial common sense in the view that if an asset bubble is perceived to be forming then monetary and fiscal authorities should move to halt its growth or attempt in some way to manage it. The hope is that by doing so you prevent the hyperinflation of the balloon and its eventual, inevitable collapse. Negative effects are therefore minimized and financial instability is avoided.
There are, though, several caveats to this approach. The first, of course, is identifying whether a bubble exists and then whether it represents an unacceptable risk. Many bubbles are perceived as they form, but others are less obvious and therefore less addressable. It appears that just the initial step of identifying a bubble can prove an inordinately high hurdle to cross since there is still disagreement on whether a bubble preceded the ’29 Crash.
A second problem is determining if we are dealing with a rational or irrational bubble. It may seem straightforward to some – all bubbles are irrational – but that simplistic view is likely to result in bad policy on many occasions. The policy prescriptions will be different for each type of bubble and applying the wrong ones can make matters much worse.
A third problem is deciding whether or not to take steps to address the bubble, rational or irrational, and what steps to take. A simplistic view would be to always say “yes,” we should address the bubble creation because of the problems they create when they burst. Again this shows no differentiation in bubble types, but it also may force action where none is called for.
It may be that no bubble exists until we turn a situation into one. Does a bubble exist in real time or only ex post facto? Does a bubble exist only once it bursts? Before it bursts, it is unclear if the bubble is going to get bigger, burst, or slowly deflate. It may do any of these three of its own accord or as the result of changes in policy. We can, through our actions, turn a potential bubble into a burst bubble with all its consequent effects. A Ponzi scheme may best illustrate this. A Ponzi scheme will work until it no longer works, until there are no more entrants. But until that time, the Ponzi runs smoothly and all is well. Losses can be hastened, though, and their incidence shifted to different entities than would otherwise be the case if shut down prematurely.
This desire to stop a bubble assumes the rightfulness and usefulness of addressing a bubble. It does not take into account that there may be more to be gained by letting bubbles run their course than by cutting them off. The consequences from cutting off a bubble on the downside are more readily apparent, but there may be upside benefits lost as well.
One of the benefits, and perceived negatives, to the bursting of an asset bubble is that it clears out a lot of the weak participants in the sector and redirects investment to the stronger ones and other sectors. This leaves the survivors stronger and better capitalized to move forward once the sector starts to recover from its plunge. Any curtailment of this process will likely lead to fewer participants being weeded out, leaving more competitors fighting for a limited pool of capital, personnel, and business. The recovery may take longer as a result and a second wave of purgings will occur as the weak competitors finally bow out. Curtailing the bubble will not change the outcome, but will stretch it out over a longer period of time and could result in greater losses rather than fewer if the second purge carries out some competitors that would have survived if only one purge happened. It may also lead to greater concentration of the sector than would otherwise have resulted. Who survives will change as well. Japan may be a prime example of this outcome, suffering a decade-long stagnation because the process was short-circuited.
Cutting short a bubble may have long-term negative consequences for the competitiveness of the sector by failing to attract the right competitors to the market. It appears to be assumed that those who arrive early to the bubble and those who arrive when it is still not in hyperinflation fare the best in the long run. Those who arrive at the end of the cycle are felt to be the weakest, least capitalized competitors and basically serve as fodder for the bubble’s growth. It is not clear, though, which group of competitors fares best in the long run and by keeping out the late-comers we may be denying some of the best competitors their shot at success. Some large, deep pocket players may not arrive until late in the game as well after surveying the sector for the best entry point. Even if it turns out that they who come last to the party are the worst dancers, they may still fill a vital role in the creation and destruction processes that will go unfilled and reduce the competitiveness of the sector. We create winners and losers in this way who might not have filled those roles otherwise.
Slowing the bubble may also slow down adoption of new technology and slow its pace of innovation. The bubble is created by the rush of new entrants and financiers to the sector, and that creates its own momentum for adoption of the new technology while increasing the rate of innovation. If the bubble is cut short, the technology may not achieve a critical mass needed to bring forth the best variant of a technology and result in a less innovative change than it would otherwise.
The stated reason for addressing an asset bubble is to minimize the fallout from the bubbles and to avoid any financial instability they can cause. What seems to be unstated is that we should really be trying to enjoy the benefits of the bubble and avoid its costs. Part of the attractiveness of creating a bubble is the thrill of the ride. It is akin to the thrill of a freefall jump, it’s just that sudden stop at the end that’s the problem. Through the wonders of technology and ingenuity, we can now experience the thrill of the freefall, yet avoid that nasty stop at the end. Bungee cords, quite literally, allow us to experience the thrills of a fall and live, not only to tell about them, but to do it again.
It appears that this is what many are seeking when they argue for intervention to address asset bubbles. They want to enjoy the ride and benefits of the bubble, they just don’t want to pay the price at the end. They’re looking for a bungee cord monetary policy that will allow us to enjoy the trip and not fear the landing since there is none. Just when disaster approaches, the cord snaps us back and saves the day. We are relieved, but thrilled. Let’s do it again.
Greenspan is correct when he states the Fed did the right thing by not popping the Nasdaq bubble. It is painful for those who have gone through the process, but any action would have just shifted the incidence of the pain and prolonged it. He is right, too, because the bubble had a rational basis and short-circuiting its run would have lead to inefficiency and stunted innovation. There is no doubt that there has been a great deal of pain brought about by this collapse and that many are looking for a way to stop the pain next time. To do so, however, will leave our economy more not less vulnerable.