Wednesday, April 27, 2011

The Usefulness of Bubbles

Businessweek is out with a great article on the current tech bubble. The article asserts that this bubble, built around social media and online advertising, is wasting a generation of talent and channelling innovative capitol towards a category of technology whose social benefits are ambiguous.

An economic bubble is basically a localized trend of inflated asset prices. Since prices are the conventional measurement of a thing's social utility, inflated prices result in misallocation of productive forces, like money, talent, or even social prestige. Most bubbles quietly deflate before anybody notices, but sometimes they continue to grow and end up popping suddenly. This usually causes financial turmoil and triggers broader economic hardship.

On the surface, this article's premise is straightforward: bubbles are terrible for the economy, and the current tech craze is exhibiting disturbingly bubble-like behavior. Thus the current tech craze is terrible for the economy. I generally agree with this logic, but it does paint diverse economic situations with a very broad brush. Within the framework of "bubbles are bad," what's the best way to compare potential bubbles (e.g. bubble A is worse than bubble B)?

Magnitude is important, but if we're looking at potential bubbles instead of past bubbles, this can be difficult. Given the extreme uncertainty of future economic events, I'd argue that one good test would focus on a candidate bubble's social usefulness. All bubbles, in varying degrees, maul the economy and ruin countless lives. Yet when the dust settles, they always leave behind certain new technologies or structural changes. Even if we can't predict how damaging a bubble will be, we can still ruminate on and compare these after-effects.

Think about it: after the financial crisis of 2007-8, what were we left with? Tons of arcane financial "instruments," ridiculously flawed arbitrage markets, and lots of cracked-out quantitative risk models. Some legacy, huh? Now consider the railroad bubble of the 1880s. When it popped, the U.S. economy was badly damaged. But we were left with a massive intranational network of railroads, establishing the infrastructure base for future development and growth.

Consider an environmental technology or energy efficiency bubble. It might pop and crash the economy, but at least we'd have made enormous social progress. By the same token, some people have suggested that we're currently in a higher education bubble, with the cost of college ridiculously high relative to it's value. That may be, but at least colleges and universities are building awesome new facilities and research infrastructure that has tons of lasting value. All bubbles hurt, but it's nice to know that, at the end of the day, our economy's persistent drunken crazes are at least doing something useful.

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