In Praise of Speculators
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.
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.
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.
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.
Let's go back to the dot-com example. What's remarkable is just how quickly the Internet economy was established during that so-called era of fictitious value. "The conventional wisdom is that the period of exuberance during the boom period--especially 1999 and 2000--was a bubble," writes BusinessWeek Chief Economist Michael Mandel in his book Rational Exuberance. "It carries connotations of something fragile, which was never quite real in the first place."
But rather than a bubble, argues Mandel, the second half of the 1990s could just as easily be called an "age of exploration." "The low cost of capital enabled risk-taking people and companies to try out lots of new ideas simultaneously, and on a large enough scale that they got a fair test," he writes.
And some bubble beneficiaries ultimately stand the test of time. During the dot-com boom/crash, the online grocer Webvan went out of business but bookseller Amazon (AMZN) survived, and eventually found its way to solid profitability. Web browser pioneer Netscape essentially disappeared, but Google (GOOG) triumphed.
Put it this way: Bubble moralizers greatly underestimate the vital role of speculators and speculative markets in allocating resources toward an economy's fast-growing sectors and away from stagnant industries. "The stuff built during infrastructure bubbles--housing and telegraph wires, fiber-optic cable and railroads--doesn't get plowed under when its owners go bankrupt," writes Daniel Gross in Pop! Why Bubbles Are Great for the Economy. "It gets reused--and quickly--by entrepreneurs with new business plans, lower cost bases, and better capital structures. And when new services and businesses are rolled out over the new infrastructure, entrepreneurs can tap into the legions of users who were coaxed into the market during the bubble."
Now, let's fast-forward to today. Much of the rise in prices for oil (and food for that matter) reflects the growth of India and China. But remember all the warnings about the developed world's eagerness to invest in China, India, Vietnam, and other emerging frontiers of global capitalism, how it had all the earmarks of a bubble. The bubble worriers will eventually be proved right. Too much money is flowing into emerging markets.
But take a step back. While the "hot money" is flowing in, the investment is building ever tighter and stronger economic ties between the developed and developing economies, creating wealth at an unprecedented rate, building bridges that will strengthen in coming decades. And it's the growing economic vigor of a vastly healthier global economy that is pushing up the price of commodities. These higher prices are encouraging enormous increases in investment in alternative energy and increased agricultural production.
Meanwhile, the Fed (as well as other central banks) should continue to develop the expertise and authority to limit the downside damage to the financial system and the real economy when prices abruptly tumble. Ben Bernanke is leading the way.
Will the boom go bust? Of course it will. Fortunes will be made and lost. Investments will coin money or vanish. But much of what will remain will be real, and of lasting value. Thank you, speculators