The necessity of bubbles
Like a phoenix from its ashes
After last year’s lightning-fast and rather unexpected corona crash, the stock markets rose like a phoenix from the ashes. The world’s most important index – the S&P 500 – is up 70% again almost a year later. You can safely call that a hefty rally. A rally that has boosted share prices to such an extent that analysts and investors are already talking about a bubble. The prices of shares – and other investments – are said to have become completely detached from their underlying value. A major crash is no longer ruled out in the markets. A warning that, according to them, investors should not take too lightly. After all, soap bubbles – and the inevitable crash – are considered highly undesirable phenomena. They are economically inefficient and socially destructive. During the notorious dot-com crash, for example, a good $6,000 billion went up in smoke. And more recently, during the credit crunch, the ensuing stock market malaise shook the entire financial system.
Speculative financial bubbles arise when unrealistic profit expectations become completely disconnected from their fundamental values. In his historical bestseller Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay describes how herd behaviour and excessive optimistic expectations can lead to inflated markets. Well-known examples from history are the tulip mania in 1637, the South Sea Bubble in 1720, the Great Crash in 1929, and of course the two crashes just mentioned. Cheap money and feverish anticipation of the future encourage investors to invest large sums of money in exotic ventures. In the final stage of a bull market, prices were driven to unhealthy levels and the inevitable collapse followed. Many investors were left penniless.
However, not all financial bubbles are by definition value-destroying. According to economist Carlota Perez, bubbles and technological innovation often go hand in hand. According to her, air bubbles can be seen as a necessary part of an innovative process. Without financial bubbles, many technological innovations would never have happened. She gives five examples from history. The industrial revolution, the rise of the steam engine and the railways, the electricity revolution, the advent of oil, the car and mass production, and the information technology revolution. Each revolution was accompanied by bursts of wild speculation and the inevitable collapse afterward. All five revolutions, however, were followed by a golden age of unprecedented productivity growth.
It might be nice to elaborate a little on the last of these stormy developments. The huge rally in technology stocks pushed the Nasdaq to improbable heights in the late 1990s. If one complains today about overpriced technology funds, it bears no relation to the valuations at the end of the last century. Investors could easily put together a basket of popular stocks with price/earnings ratios of over 100. In fact, a huge advance was made on a golden future. Of course, this madness went wrong. What is often overlooked, however, is the fact that the Internet madness of that period directed many billions into investments that actually turned out to be productive. It turned out to be a period that was brimming with innovation. Companies like Amazon and Google might otherwise never have seen the light of day. Without the millions of kilometres of glass fibre cable, the internet would never have been able to take off in the 20 years that followed.
Bubbles are good, even necessary
Of course, individual investors who saw their assets evaporate had little to do with this. But society as a whole certainly did not emerge worse from this dot-com crisis. Without the ‘wasting’ of thousands of billions on all kinds of technological failures, the successes would never have happened either. And here the line is extended to the current craze in ESG stocks. It is clear that, once again, many billions are being wasted on investments that will turn out to be completely uneconomical in twenty years’ time. However, the many investments in solar panels, wind farms, artificial intelligence, 5G, electric vehicles, and lightning-fast semiconductors will undoubtedly lay the foundation for a new technological revolution. A revolution that, in turn, can lay the foundations for a new golden age of productivity. Air bubbles are not only good, they are even necessary.