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Pop TalkDaniel Gross chats with readers on why economic bubbles are good.

Posted Thursday, May 10, 2007, at 5:56 PM ET

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.)

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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.

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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.

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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.

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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.

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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.

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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.