The Economy almost certainly needs Bubbles.

Larry Summers shocked everyone recently with his speculations on the links between growth and bubbles. some people slightly agree, others do not. For example, Clive Crook disagrees with the premise we need bubbles for the economy to work properly.

I have been thinking about the link between bubbles and growth for nearly 3 years. Back in my Traders Crucible days, Nick Rowe wrote a post on bubbles which really caught my attention. He pointed out an old paper by Paul Samuelson gave some insight into the reason the (completely wrong) Intertemporal Government Constraint might not hold.

“There is something economists have known since 1958 that we don’t talk about much, except in private, like in economics journals that nobody else reads. It’s a bit too weird.

There are two sorts of world. In a normal world, the equilibrium rate of interest is above the growth rate of the economy. In a weird world, the equilibrium rate of interest is below the growth rate of the economy. What’s weird about a weird world is that it needs a bubble, a Ponzi scheme, a chain-letter swindle, for the economy to work well.

Maybe the world we live in is a weird world. And it needs a bubble to work well. And the economy keeps trying to create a bubble. And when it succeeds the economy does work well. But bubbles are unstable and eventually burst. Then it works badly again. Until the next bubble.”

I have been publicly silent on this idea for a while, but this does not mean I’ve stopped thinking about the relationships between g (the real rate of growth) and r (the rate on interest on publicly held government debt) and another r (the natural rate of interest).

I do not believe in an economy wide natural rate of interest. It does not seem to be observable in real time, or even easy to determine it’s general level years after the fact.

(Aside on the natural rate of interest: Here are more problems with the NRoI. The inputs to determine the “natural rate” are hard to measure. The NRoI suffers from ex-ante, ex-post problems. The NRoI doesn’t meet basic criteria for effective real time guidance. The economy is ergodic, so what use is a NRoI? It also seems mis-specified in that it targets an low quality economic equilibrium of stable prices. The Investment/Savings aggregation problems. Aggregating a yield curve into a single interest rate is nonsense. NRoI implies lending, which implies borrowers and lenders, and borrowers and lenders are not uniform at all. The NRoI highly dependent on institutional structure. I have some writings on this which will come out over the next few weeks. There are more…)

But for now, just forget the problems with the NRoI. Take the NRoI model at face value, like Larry Summers does. What does this mean in the context of the Paul Samuelson world? Do we live in this weird world, where g is higher than r (the natural rate of interest)? More specifically, do individual economic sectors (such as real estate) live in this weird world?

Yes we do. We currently live in a world where growth is higher than the natural rate of interest. Everyone who thinks there is a natural rate of interest believes the NRoI is negative right now. Miles Kimball, Brad Delong, Paul Krugman – nearly any economist who abides by the NRoI model believes the NRoI is negative.

The economy needs a bubble in order to function properly when g > r.

They also believe g, our real rate of growth, is positive today and has been positive over the last several years. The rate g might be low, but it’s well above zero, probably somewhere around 2-3%. Technology is advancing at some non-zero rate, which *must* force growth to be higher than zero. In any case, real GDP has been growing.

These circumstances put the U.S. economy into Paul Samuelson’s world where we can get a free lunch, as long as we have a bubble. We get extra growth at no cost of inflation. Our lives are better off with the bubble.

My take on this is the economy demands bubbles when r <g. That’s right – demands bubbles. If the bubble is not met, it will try and find a way to create this bubble. (See real estate, stock market, S&L, Emerging Markets) Artificially constraining the bubble forces unnecessary misery on people, and causes involuntary unemployment and unused capacity, which is bad because it causes an economic incentive for war.

How large does our “bubble” need to be for the economy to function properly? This should be an empirical question.

What does a “bubble” mean? I have a post on this, but bubbles and money are closely related. Bubbles can only happen within the structure of a money creation process. Nick talks about this in his post:

“Samuelson called the chain letter “money”. But it could be an unfunded government pension plan. Or gold could serve the same purpose, even if gold were intrinsically useless except as a store of value. Whatever it is, it’s a bubble, that has a market value in excess of any intrinsic value.

But if the marginal return on capital, after an allowance for risk, is less than the growth rate of the economy, it still needs a bubble. A chain letter, or bubble, can grow forever at the growth rate of the economy, as long as people believe in it and don’t break the chain. And it can pay a rate of interest equal to the growth rate. So people save partly in real capital, and partly in the bubble, and both pay the same risk-adjusted rate of return, equal to the growth rate. (The marginal rate of return on capital rises as the capital stock falls when people hold less capital and more bubble.)

Land may also alleviate the problem, in the same way that capital does. But land is different from capital because they aren’t making it any more. That means that land may also serve as the bubble asset, with the price of land made up of a fundamental component equal to the present value of expected rents, plus a bubble component, with the bubble component growing at the growth rate of the economy and yielding capital gains. And house price bubbles are really just bubbles in the price of the land on which the house sits, because the house itself is just reproducible capital.

Governments can create the bubble, with a national debt they never pay the interest on, but just rollover from one year to the next. A Ponzi scheme. If spending and tax revenues grow at the growth rate of the economy, and that growth rate is above the rate of interest, they can do this forever. The long run government budget constraint just doesn’t add up, literally.”

This isn’t an easy topic at all. This gets right to the heart of our economic system. It’s easy to make mistakes, and I don’t claim to have anything close to an understanding of how this works. Remember, I do not think the NRoI is something that exists economy wide, but is something which is rather sector/geographically specific.

Yet, with the discussion kicked off by Larry Summers.

More Points:

  • r is impacted by our institutional structure. We can change this with our monetary, fiscal, credit, and foreign sector setup. We could live in bubble land forever if we wanted.
  • g isn’t entirely outside our control either…
  • if r and g are sector specific, then some sectors will demand bubble or anti-bubbles (where the sector wants to destroy money). This should be extremely confusing to the “economy”.
  • While r is impossible to sum
  • This adds some color to the observation deflation incentivizes war. Deflation/Depression attempts to force g down to r, rather than bringing r up to g. People don’t like this
  • It seems like we’ve lived in bubble land since we abandoned Bretton Woods and Functional Finance in 1973. If we take the estimates of the NRoI at face value, there is a decent chance we are in bubble land for much of the time.
  • If the NRoI is negative today, then the demand for a bubble must be very large today. The spread between NRoI and real growth is very, very high – possibly as high as 5%
  • When r < g, we demand a bubble. If r < g for more than a few years, we need a bubble.

P.S. Businesses Hire when they are swamped with demand.


Update: Slackwire has been thumping around this same area. His post is a must-read in context of the comments by everyone below.


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65 Comments on "The Economy almost certainly needs Bubbles."

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3 years 9 months ago

Sounds like we have too many capitalists who are saying, “Unless we can win the lottery with this investment we aint investing” Which actually seems quite a rational strategy when you have lots of wealth to protect. Its been shown time and time again that moderate losses affect us more negatively than consistent small gains affect us positively (from a psychology standpoint) But this becomes self reinforcing. Everyone with wealth refuses to invest so incomes suffer and the people with wealth find that their businesses start suffering from lack of demand.

To add to Stones point;
” In that way bubbles could actually end up dragging down the real economy -quite the opposite of what it is said that they are needed for.”

I agree, its kind of like a team with Michael Jordan on it sitting back and waiting for Michael to win it. When Michaels the only one playing basketball its hard for his team to win. The housing bubble at least involved lots of sectors of the real economy, many of which did back breaking work (real production) but it was all the financialization of the mortgages and all the side bets on the default risks which made it unstable and eventually led to its demise. Stock market bubbles or any other financial bubble will always end badly in my view. We dont need any more tech stock or any other financial product bubbles

3 years 9 months ago

Does this all depend on “capital” actually suffering a net loss from bubbles such that they cause a trickle down?
I wonder whether as more “capital” concentrates with sophisticated speculators and as the TBTF culture causes losses to be socialized, “capital” overall might actually TAKE more from the economy by harvesting bubbles than gets tricked down.
It doesn’t even take much sophistication does it? Just cash to spare? If someone kept say 75% cash and 25% or some bubbling asset and rebalanced periodically as that asset rose to the stratosphere and then fell all the way back down to the start, then they would have profited wouldn’t they? The counterparty that was paying for their gains could be the real economy. In that way bubbles could actually end up dragging down the real economy -quite the opposite of what it is said that they are needed for.

3 years 9 months ago

Interesting series of posts.

Question on this one:

I can see (maybe) why the economy induces bubbles in this circumstance.

But what is really meant by saying the economy ‘needs’ bubbles?

i.e. ‘needs’ to what end?

3 years 9 months ago

I guess they mean we need the increased spending that comes from the associated malinvestment? -Jobs building ghost estates of unwanted houses, empty shopping malls, lawyers writing patents for daft pretend biotech bamboozlements or whatever?

3 years 9 months ago

Your make the crucial point, “r is impacted by our institutional structure. We can change this with our monetary, fiscal, credit, and foreign sector setup. We could live in bubble land forever if we wanted.”

IMO, the need for bubbles comes because our financial system fails to reflect the reality that every unused hour of potential machine or worker time is permanently lost. Currently, we can preserve wealth over time using our financial system even if we are not using it productively- that is the key distortion that destroys our economy IMO.
There would be no need for bubbles if a maintaining wealth over time required a strong stream of dividends in order to collect enough funds to pay an asset tax.
Bubbles basically are a sort of asset tax in that they flush down the toilet a lot of hard earned savings. The problem is that they don’t do so evenly. Smart players actually make a killing from bubbles. The bubble world misdirects the “best and the brightest” away from developing new technology (or organizing a productive economy or whatever) to instead working for hedgefunds and investment banks creating and harvesting bubbles. The people who get fleeced by bubbles are often the people who have been concentrating on contributing to the real economy (or are just foolish I guess) and have had a dumb casual exposure to the bubble. I guess many haven’t even stopped to think that recovering from a 75% loss takes a 300% gain.