Daniel Gross was online at Washingtonpost.com on Thursday, May 10, to discuss his Slate article " Pop! Why Bubbles Are Great for the Economy," also the title of his new book. An unedited transcript of the chat follows. (View the Bubble Hall of Fame, take a Bubble Quiz, and buy Pop! Why Bubbles Are Great for the Economy.)
Daniel Gross: Hi Everybody — Thanks for joining me. Why do I think bubbles are good? It has as much to do with what happens *after* the bubble bursts as it does to do with what happens during the bubble. In the U.S., we've had this great history of innovation that comes after the Pop!
Basically, the excess capacity that gets built up during bubbles (telegraph, railroad, Internet) winds up serving as a really powerful, cheap, and pervasive platform on which new businesses are constructed. So the people who strung up the telegraph wires in the 1840s and 1850s all lost their shirts, but the telegraph proved really important to the business models of the Associated Press and stock exchanges. Investors who backed railroads in the 1880s lost all their money in many cases, but companies that relied on freight to conduct business (Montgomery Ward, Sears, Coca-Cola, Procter & Gamble) were able to gain scale quickly.
More recently, companies like Global Crossing and WorldCom, which built the Internet infrastructure in the 1990s, failed quite loudly. But in the years since, all sorts of businesses have been built on the wreckage -- Google being the most obvious example.
The argument, then, is that the excess capacity built during bubbles, which winds up hurting the comparatively small number of people who invest in the bubble companies, winds up being a net positive for the mass of consumers and for the economy at large.
North Salem, N.Y.: I remember the solar craze of the mid-'70s. Why is it that a country like ours cannot find a long-lasting alternative to fossil fuels, etc.?
Daniel Gross: Hi — Actually, I think we are in the process of finding a solution. As you note, there was a solar boom after the oil shock of the 1970s. In my book, the final chapter deals with alternative energy. Are we in an alternative energy bubble? Not quite, but we're almost there.
You can really see how alternative energy has grown rapidly in recent years, and has become something of a popular culture phenomenon, whether it's "An Inconvenient Truth," or Wal-Mart selling compact fluorescent bulbs, or Rupert Murdoch talking about global warming and carbon neutrality.
That's being matched by significant investments. And, importantly, the government is playing a role. In virtually all the infrastructure bubbles to date, the U.S. government has played a bigger role than most people think. And in alternative energy, state and federal governments are big players. Through subsidies, tariffs, and a range of initiatives, they are stimulating huge investments in alternative energy.
Many of these companies will ultimately fail. But if this cycle works out like the previous ones, we'll be left with important usable infrastructure that will set the stage for new innovations. It's a safe bet that in the next several years, even if solar companies fail, the price of solar installations will fall.
Anonymous: Bubbles? Or simple rotations from one asset class to another?
Daniel Gross: There's definitely been a rotation from asset class to asset class--real estate got hot right when the NASDAQ melted down, and alternative energy got hot right when housing peaked.
But I think in this decade we've had back to back to back bubbles in technology, real estate, and alternative energy. Bubbles are hard to define, but there are a series of stages I outline in my book that help you know when you're in one: you get a few good years of solid fundamentals, then you get promoters arguing that something fundamental has changed (about technology, or the economy, or our world) that justifies investments at any level, then it crosses over into the popular culture and ropes in millions of new enthusiastic users.
Alexandria, Va.: I've got all my money invested in black tulips. Want to buy one?
Daniel Gross: I'll trade you one share of Webvan for a black tulip!
Harrisburg, Pa.: When I studied economics in college, including econometrics, I was taught that economic statisticians can have some accuracy on predicting ongoing trends. What was very difficult and almost impossible to predict was when trends would reverse, i.e. when economic bubbles would burst. Has there been progress in recent years in better determining when economic bubbles suddenly will downturn?
Daniel Gross: That's a great question. And unfortunately the answer is no. I've written a couple of articles in recent years about the challenge of economic forecasting. If you look back when we had the last recession back in 2001, the quarter before the recession started, all the forecasters were predicting smooth sailing. And the quarter when the recession ended, all the economic forecasters were predicting that the economy would continue to contract.
The state of the art of economic analysis has improved vastly in recent years, but economists tend to do very poorly at noting turns. One group -- The Economic Cycle Research Institute -- has done quite a good job in seeing turns. And they like to say that their fellow economists engage in too much of forecasting by analogy -- i.e. they simply extend existing trends into the future. It sounds reasonable. But it means that when there's an interruption, or a shock, or simply some unexpected occurrences, the forecasting goes haywire. Frequently, peaks in markets, or in sectors, are only seen in retrospect. And, as investors know, it is exceedingly difficult to time markets.
Rochester, N.Y.: I'm not convinced. Sure, some bubbles promote things we find useful (Internet, rail), but in some case the upside is limited: I'm sorry, but Zillow.com is good for voyeurs but not terribly helpful. And there's a bubble downside, too: how on Earth can young people afford to live on the coasts (other than to use a zero-down, negative-amortization option adjustable-rate mortgages)? How did the tulip bubble help anyone?
washingtonpost.com: Tulip mania
Daniel Gross: Hi Rochester — thanks for your question. I'm with you on the Tulips. Nobody benefited from that (except for economic historians who received a subject they could discuss for years.) I'd urge you to read the book for a fuller explanation. But in a nutshell, I'd say this.
Not all bubbles are great for the economy. It's only those that result in the creation of a new commercial or mental infrastructure that can then serve as a platform for other businesspeople.
In the U.S., unlike in Europe, the government doesn't build new commercial infrastructures. The state didn't roll out the telegraph, or the railroad, or the Internet, or an ethanol industry. Instead, the private sector did it. And frequently, when the private sector seizes on a hot new idea, a bubble follows. Bubbles can be good for a couple of reasons. First, they result in the rapid roll-out of new technologies. The U.S. got wired for telegraph, and railroad, and Internet as a result of bubbles. Without the lure of quick riches, investors wouldn't have piled in the way they did, and created competing companies that bashed each others brains in and cut prices furiously to lure in new users.
bubbles also result in what I call "mental infrastructure." By that I mean that during bubbles lots of money is spent on hype and promotion. Think back to the 1990s, when dot-coms spent so much money and ran businesses on negative margins to get people to buy stocks or books or airline tickets on line. A lot of the pioneers lost money and went bust. But they left behind a wired population that was accustomed to buying stuff online. What that meant was that someone who came along in 2002 with a new idea for doing business online (blogs, selling advertisements, a video site, whatever) they could tap into this cheap physical infrastructure and a huge installed base of potential customers.
Regarding housing: it's always nearly impossible to see the upside of a bubble after it pops. Back in 2001 or 2002, nobody could have foreseen that Google would be a $150 billion company by May 2007. The fact is that we just don't know what upsides may come about.
Finally, re: all the people priced out of the coasts. one of the things we have seen in recent years, as a result of the bubble and challenge of affordability on the coasts, is more people moving inland--leaving California for cheaper housing in Utah or Missouri, or leaving New York for Philadelphia. For areas that have been losing population (like upstate New York), really expensive housing on the coasts may prove to be a lure for young people to move there.
Wilmington, Del.: Based on my favorite obscure economic indicator, the DGI (the Daniel Gross Indicator) I'm doubling the odds that May 9, 2007 will go down as the end of Bubble 2.0. More seriously though, why did you leave the Alan Greenspan of the roaring '20s, Secretary of the Treasury Andrew Mellon, off your list of the greatest bubble promoters of all time? I've read that he was considered just as powerful an economic figure as AG ever was, and that it was joked at the time that three different presidents worked for him.
Daniel Gross: Thanks for your note. Indeed, as a mainstream journalist I may very well be a contrary indicator. In that spirit, I'll hereby proclaim that today marks the end of the Yankees as a great baseball franchise!
Regarding the list of great bubble promoters, Paul Mellon surely belonged. He was the Treasury Secretary during the 1920s, during the bull market, and became one of the villains of the bust. In my book, a cite one of his best-known quotes. As the country plummeted into Depression, he said that the widespread deflation was a good thing. "high costs of living and high living will come down. People will work harder, live a more moral life." One of his other gems: "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." This, of course, was at a time when he had just spent about $7 million to buy a huge chunk of paintings from Russia's Hermitage museum.
But on this list, I was going for the one or two most willfully blind and baselessly optimistic people for each bubble, and Mellon was a little too sober to make the 1920s list.
Silver Spring, Md.: This housing bubble was awful! It lead to horrible teardowns of beautiful small homes and their replacement with McMansions. More McMansions were built on farmland. Hulking condos were built, with little chance that the people who live in them can afford to buy them. They will miss out on the physical and emotional security of home-ownership. We need to preserve the housing and trees we have. Investors should target contraception and small houses -- strategies befitting a small planet.
Daniel Gross: I agree with you somewhat about the aesthetics of the housing boom. My Slate colleague Witold Rybczynski has a great new book out called "Last Harvest," which traces the history of a recent housing development in Pennsylvania that is probably more along the lines of something you would approve of.
Laurel, Md.: Bubbles occur when price momentum becomes a factor in people's value calculations. When buying something one never expects to resell (a pair of shoes) or to resell only at substantial loss (a car), a sensible person figures: "How much does it cost? What use does it have to me? Is it worth it?"
A bubble starts when people add "can I resell it two years from now for double I paid?" to their cost-benefit analysis. In your May 9 Slate column you describe the benefits of bubbles reasonably well. In the same way that stocks are a better investment than certificates of deposit unless every penny is dear to you, economic mania's often are based on a legitimate perception that a new era has begun. Railroads, autos, electronics and computers led to stock market booms in the 1880s, 1920s, 1960s and 1990s -- and busts the following decades.
The difference today is that the average person is participating in the busts. Back when only the wealthy owned stock, the public could legitimately regard stock manipulation as a kind of game rich people played with each other. Now that we're "all" in the market, things like Enron and the real estate bubble cost people their "necessary" money (for retirement or their home), not just their fun money.
Daniel Gross: Laurel, Md. -- you're right on regarding the growing participation of individuals in bubble activity. You know, we like to think of the U.S. as a nation of investors, but it's only really recently that we became one.
If we go back to the railroad bubble of the 1880s, it wasn't financed by American institutions, banks, or individuals -- we really lacked the financial infrastructure to support large-scale financing efforts. The government had to provide or guarantee financing for the transcontinental railroads. In the 1850s, taxpayers effectively provided about one quarter of the $737 million invested in railroads. No, it was Europeans who financed the railroad boom. Between 1865 and 1900, Europeans bought about $2.5 billion in American securities. So the U.S. got a great deal: foreign investors took big losses, and we got to keep all those rails.
Just so, in the 1920s, as much as the stock market was a topic of conversation and imposed itself on the popular culture, at most 10 percent of households were investors. In 1929,the member firms of U.S. exchanges counted just 1.55 million accounts. So, again, the stock bubble was confined to a small number of people. However, the 1920s also saw a bubble in all kinds of credit -- car loans, home mortgages, consumer credit for appliances -- that did involve many more people.
The more recent bubbles have swept up a greater chunk of the population. By the end of the 1990s, about half of U.S. households owned stocks in some form. And of course nearly 70 percent of Americans own homes today.
Tampa, Fla.: Do you think the "information revolution" is also having an impact on the rate of bubble formation -- as in, more people wising up to "the next hot thing" more quickly?
Daniel Gross: Hi Tampa -- thanks for your insightful comment. Yes, I do think the information revolution is having an effect on the formation of bubbles. Clearly, it was behind the 1990s bubble in technology stocks. I think part of it is, as you point out, that thanks to communications technology, more people learn about hot new sectors more quickly.
But I think there's something deeper than that, which has to do with the Internet as a commercial platform. It gives businesses unprecedented scale and reach, and makes it easy for businesses to deal with customers everywhere. So think about the whole refinancing business, which helped propel the boom. Every day, we get offers to refinance via e-mail. And there are Web sites like LendingTree where you can apply for loans in a matter of seconds. Then sites like Domania and Zillow.com, and Realtor.com really democratized housing-related information that had until recently been closely held by realtors. That empowered consumers, yes. But it also made lots of non-professional investors think they had the ability to invest in real estate -- after all, all the tools were there online: the money, the listings, the data on comparable sales, the ability to market properties. So, yes, definitely, I agree that info. technology helps propagate bubbles more quickly.
Seattle: The question is, are economic bubbles good for disrupting concentrated, inherited, non-earned wealth in a stratified society, or are they good because they force a revaluation of the relative prices of goods and services?
Daniel Gross: That's a good question. Bubbles certainly do disrupt the established order, and they certainly do affect pricing. My argument has more to do with what they leave behind, and with the effects of the brutal competition they engender. When you get excess capacity in anything -- railroads, telegraph, Internet, condos -- it stimulates price wars. That's bad for entrenched wealth (i.e. the people that own the infrastructure) but really good for consumers, and even better for businesses that rely on this infrastructure for distribution.
To a degree, all the greedy types who plunge in and say "I'm going to build a fiber-optic network to compete with the 50 other ones out there" -- are doing the rest of us a favor. They build the infrastructure, they discount furiously to attract traffic, and when they go bust, the assets get taken over by someone with a lower cost structure -- who can keep prices low, too. We all get the benefits of the infrastructure for the long term even if we don't all pay for it.
New York: You mention that one of the reasons that bubbles can be good is because "the excess capacity that gets built up during bubbles (telegraph, railroad, Internet) winds up serving as a really powerful, cheap and pervasive platform on which new businesses are constructed." Could you apply this analysis to the housing market?
Daniel Gross: Hello New York. Yes, I think you can apply this to the housing market -- though not as directly as you can to the Internet and railroad and telegraph. I do have a chapter on housing in the book.
So here's how it could benefit the economy. Bubbles leave behind commercial infrastructure. In the case of housing, that's all the homes that were built, all the condos. They won't get torn down. They might have to be sold by some people at a lose, but they'll be taken over by other users. A condo tower in Miami that doesn't sell might be turned into a hotel, or office buildings, or a dorm. So we get to keep that infrastructure.
In the book I also talk about the importance of the mental infrastructure that is built during bubbles. By mental infrastructure I mean the modes of doing business, the willingness to try new things. In the 1990s, companies spent lots of money convincing people to buy stuff online -- that mental infrastructure (millions of consumers willing to do transactions online) survived the bust and proved enormously valuable to the next generation of companies.
With housing, I think the mental infrastructure will prove to be the whole culture of refinancing. This whole system and mentality was built up to allow people to refinance. Lots of people got hurt with bad mortgages. But millions more benefited by refinancing fixed-rate mortgages every time interest rates dropped 50 basis points. People also realized that it was preferable to borrow against home equity at 8 percent or so than to borrow on credit cards at 20 percent or so.
What's more, new products like housing index options were introduced (although very few people use them) during the bubble.
So if the end result of the housing credit bubble is that we have a home-owning base that is aware of the benefits of refinancing (and will do so when interest rates next cycle down) that could be a net positive for the economy.
Boston: Lets by fair to Greenspan and others who suggested adjustable-rate mortgages -- they are good because they are a one-sided bet, and you always can refinance if rates are rising. That is just simply true. It's not the economists' fault if the media changes it to a headline saying "Greenspan says 'go get an ARM' " and people who have bad credit and can't ever refinance follow this advice. Filtering out foolish people is another useful tool of markets.
Daniel Gross: I'm with you to a degree. ARMs are brilliant in theory, less brilliant in practice when people use them as an excuse to get into a house they can't afford when rates re-set higher. The problem of this decade was that people had convinced themselves that interest rates would never rise and that home prices would never fall.
Dayton, Ohio: So can we conclude that the "first mover" advantage is not always there? Sometimes it's better to hang back and wait for the pioneers to go bust, and then go in to taking advantage of the infrastructure and new commercial landscape they've left behind?
Daniel Gross: Absolutely. That is very much the point. Time and again, the first movers, who all thought they were going to make a killing, ran into trouble when they ran into ten other first movers doing the same thing. That's one of the distinguishing things about the U.S. economy. A good idea gets funded ten times. In the 1840s, there were three competing telegraph lines connecting Boston and New York. but there wasn't enough traffic to sustain one, and they had to compete furiously on price, which caused them to go bust. The same thing happened with railroads -- we had four or five transcontinental lines instead of one or two. And of course, with the Internet, there were so many copycats in every sector that it made it very difficult for companies to make profits when demand didn't materialize as expected.
Baltimore: Re: Housing bubbles -- interesting piece in the New York Times on Tuesday (I think) about all the newly rich Irish buying up condos in New York that they plan to rent out. It seems that, despite skyrocketing real estate prices in Ireland, the rental markets have remained flat, so the Irish are looking to New York, where the rental market keeps going up. If we see a condo crash in New York (as we have in Washington and other cities), it could have quite an impact on Irish investors.
washingtonpost.com: An Irish Taste for Real Estate in Manhattan(New York Times, May 8)
Daniel Gross: I saw that article too, and it's quite fascinating. Ireland a decade ago was one of the poorer economies in Europe. Now it's generating sufficient wealth to invest overseas. And the subtext of this whole article is that the weak dollar -- which makes it so miserable for Americans to try to buy property in Europe these days -- is making it quite easy for Europeans to buy U.S. real estate.
Annandale, Va.: I still don't get how the housing bubble deflation is good for the society at large. Your earlier answer to Rochester said high housing costs might spur migration away from the Big Apple to places like ... Rochester. That makes sense. But as housing values plummet in California, Florida and to a certain extent in the D.C. area, what is the greater public good served? It's not like these cities, with lower-priced but still pricey real estate, need a new net influx of people.
Daniel Gross: Good point. The point I make in my book is that it's hardest to see the benefit of bubbles right after the pop. We get irrationally exuberant, and then we get irrationally pessimistic. Back in 2001 and 2002, we were convinced the Internet was a scam. Well, e-commerce today is a gigantic, gigantic business. Google, a company that barely registered on the radar screen in 2002, is worth $150 billion and has a tremendously profitable business model. One hates to quote Donald Rumsfeld, but sometimes the upside of bubbles are among the "unknown unknowns."
That said, I talk in the book about the physical infrastructure that gets built in bubbles and the mental infrastructure that gets built. Both remain. By mental infrastructure, I mean the mindset of consumers--so we had this whole development of a cultural of re-financing, which proved enormously beneficial to the economy as a whole (people were able to save money on their mortgages repeatedly), and which won't go away.
Bowie, Md.: To what extent are modern bubbles caused by the fact that transaction agents (stock brokers, real estate salespeople, mortgage brokers) are paid for each transaction, not according to how satisfied their customers are over long-term results? Does this skew the discussion of "is now a good time to buy" in favor of "it always is to the supposed professionals."
Daniel Gross: Absolutely. The whole culture of selling always affects the formation of bubbles. And real estate is the prime example of that. The whole chain -- the mortgage broker who got a fee for placing a loan, the real estate agent who got a commission for selling the house, the bank that got a fee for providing the cash for the loan, the investment bank that got a fee for securitizing the loan, the brokerage house that got a fee for trading the security, and the hedge fund manager who got a fee for managing those securities. Up and down the line, the whole thing was driven by fees. Nobody really cared if the loan made sense, or if the person could handle it or pay it back.
Re: Housing boom: Also, people have been selling the properties on the coast and thus locking in the inflated gains and moving to more affordable places.
Daniel Gross: That's certainly true.
Laurel, Md.: "Boston: Lets by fair to Greenspan and others who suggested adjustable-rate mortgages -- they are good because they are a one-sided bet, and you always can refinance if rates are rising. That is just simply true." But in America, fixed-rate mortgages are a one-sided bet that can always be re-financed if rates fall. The problem wasn't was Greenspan said, it was the timing -- he said it after rates had dropped as low as they realistically could and had nowhere to go but up.
Daniel Gross: Right on.
Daniel Gross: Well, my time is up. Thanks to all who participated, and for your intelligent questions. I hope you'll all continue to read me in Slate, and will check out "Pop!"