What is a Bubble?

Brad DeLong has a long post that is another piece in the on-going hand-wringing saga of what, if anything the government should do about declining home prices. Of course, you can't swing a dead cat these days without hitting an econ professor with a blog about his brilliant ideas on how the government can single-handedly bail us all out, magically lifting the economy up by its own bootstraps, so to speak. But the post does end with a very interesting quote from Keynes:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history....

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities [over 1924-1929] could not always be in just the appropriate relation to that of others. But... [a] few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied.... It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man's speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidation' to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of [depressions, i.e.] the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity...

I find this interesting because it makes you question what exactly you mean by "a bubble". These days, we're liable to label just about anything that increases quickly in price (and can potentially decrease just as quickly) a bubble. That strips the word of any meaning though. A better definition would reserve it for a more technical use in situations where the price of something cannot be justified by its fundamental value. We speak of a property or stock bubble when the historical relation between prices and the drivers of those prices (incomes and earnings respectively) breaks down. That's a better use of the word, and maybe even a good way to predict future prices of the asset, but in practice, these types of frothy disjunctions between values and prices are not simply taken as price signals, they acquire moral dimensions. People don't call it a bubble until they feel hoodwinked.

But the other thing I think we have (re)learned about bubbles is that they also have a positive side. It's a bit of a chicken and egg question, but bubbles actually stimulate real investment, which is what Keynes is point out. The internet bubble had a building all kinds of new technology, some of which was dumb, some of which was fradulent, and some of which enables me to write, distribute and monetize (with a little help from Google) this terribly clever blog. Was that such a bad thing? Would I be able to do this without those sky-rocketing tech stocks?

At first glance, this also seems to be the way to condemn the housing bubble. Houses are not productive. They are consumer good. I'm not sure if Americans will ever understand this, though presumably their prices falling another 20% will help. The problem with the price of housing increasing is that it encourages you to build more housing, and having an even bigger McMansion doesn't actually allow you to make an even even bigger one somewhere down the line.

In other words, the housing bubble wasn't an investment bubble, and it's busting doesn't leave us with anything that we didn't have before, and especially not anything useful for future production like railroads or the internet.

But wait. Even though it was pretty indirect, the housing bubble did encourage investment -- IN CHINA. All that excess consumption in the US, all those people using their house as an ATM and racking-up credit card debt was accompanies, step for step, by the expansion of productive capacity in China. The housing bubble was their ticket to modernity. So maybe bubbles aren;t so bad after all.