A Note to the Bubble-Phobes

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Includes: DIA, QQQ, SPY
by: Eddy Elfenbein

Robert Shiller writes in Sunday’s New York Times about the collective failure to see the housing bubble. Obviously, some folks will insist that they saw everything coming, and it was perfectly predictable.

One of the problems I have with this idea, and I’ve mention this before with Shiller’s other work, is the curious idea that a bubble is somehow a problem that needs to be fixed.

Just because prices go up very rapidly doesn’t mean something is a bubble. Oddly, the only time we can be certain that it’s a bubble is when the air deflates and the asset prices go down. In other words, to the bubble-phobes, the problem isn’t the bubble, it’s the downside, and we only know what after the fact.

How can we be sure it’s a bubble when an asset inflates? In the 1950s, stock prices soared and they never really came back down. The phrase “permanently high plateau” hasn’t had a good record since the 1920s, but I think that’s an accurate description of what happened in the 1950s.

Is gold a bubble right now? What about oil? Or the Euro? Or could it be that we’re simply adjusting to a new era of commodity prices? I don’t know and for now, I’m happy to consider these open questions. I will note, however, that adjusted for inflation, commodity prices have historically plunged.

For me, the best definition of a bubble is a price that’s going up because it’s going up. The certainly happened with tech stocks in the 1990s. But I’d rather not have Alan Greenspan tell me what the prices of tech stocks ought to be.

There’s also the counter argument that bubbles aren’t merely not bad, but actively good. In his book, Pop!: Why Bubbles Are Great For The Economy, Daniel Gross writes how bubbles and their ugly aftermath have often helped lay the ground work for future prosperity. A bubble creates enormous excess capacity which can later be used to bring down the cost of applying a new technology.

Shiller writes, “The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world.” Actually, the collapsing house of cards is the recognition of the bubble. After all, the bubble could have gone on for another three years. Perhaps free enterprise spot it early and cut it off. Hooray for markets!