Greenspan: Bubbles Are a Necessary Part of Innovation

It’s no secret that former Federal Reserve Chairman Greenspan would never sacrifice the whole economy for the sake of popping a bubble. It does not matter how obvious or difficult to determine that bubble might be. Nor is he concerned whether the bubble is small or actually engulfs the whole economy. Remember the stock market wealth-affect of the 90s and the recent housing wealth-affect in the first half of this decade.

Never one to retreat from defending his record, Greenspan has regrouped and is preparing to finally defeat those attacking him. Greenspan will not be deterred by the current Federal Reserve Chairman Bernanke’s bubble study group. Greenspan has finally realized that no one is buying the 'bubbles cannot be recognized' mantra, and is setting the stage for Act 2.

In Financial Times "Greenspan urges policymakers to focus on banks' capitalisation", Greenspan argues that bubbles are a necessary part of innovation. Bubbles fund the rapid growth seeded by innovation, and are also a result (or byproduct) of the enthusiasm for innovation. Is he announcing the innovation-asset price inflation spiral? Sounds like Greenspan doesn’t know his chickens from his eggs.

Greenspan claims the internet would not have grown as rapidly without the dot com bubble to feed it, and “advances in home financing” would not have evolved as fast without our recent housing boom. It’s a tough argument to buy. The internet evolved technically far more in the last few years than during the 90s and the financial alchemy of the recent past does not appear to have benefited many. However, I do concede that the telecom bubble was an integral part in the growth of fiber optics, and alternative energy innovations gained momentum with the commodities bubble.

Greenspan’s conclusion is that banks should be adequately capitalized to handle the fallout when bubbles collapse. At this point his rant completely collapses onto itself. During a bubble both commercial and investment banks become substantially overleveraged. Greenspan would want them to keep pumping air into the innovation bubble, promoting rapid growth. How can they possibly de-lever fast enough to support the economy in a downturn? We all have seen they can’t.