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January 25, 2005

Why we need bubbles

The bubble-busters are on the loose.  The blogosphere is full of ideas for puncturing the next bubble before it inflates.  Irrational exuberance may be made a capital crime; it certainly is politically incorrect.

Preventing bubbles would do more to protect incumbents and inhibit innovation and economic progress than Sarbanes-Oxley squared and a ban on silicon and software combined.  The capital raised in bubbles is the explosive charge which launches the technologies that change the world.

Nothing great has ever been accomplished without irrational exuberance!

Radical new technologies suffer from a chicken and egg problem. Railroad tracks are useless without trains and vice versa.  Modern roads and modern cars require each other and a network of fueling and repair stations to be useful.  The modern Internet required a two order of magnitude growth in infrastructure, an enormous investment in access, huge amounts of content, and a critical mass of users – all at once. 

Everyone knows that Metcalfe’s law means that large networks are very valuable.  It also means that small networks are practically worthless.  Obviously, if you had the only phone in the world, it wouldn’t be of much use to you.  So how do little networks with little value grow into big networks?  They can’t do it based on internally generated cash because small networks lose money.  They can’t even do it based on rational expectations of future cash flow because, in a rational world, it is clear that positive cash flow is far away and, unless monopolies are granted, it is almost impossible to pick the few little networks which will survive and win when and if critical mass is ever reached.

Irrational exuberance is needed!

It was irrational exuberance which provided the capital for the huge overbuild of Internet infrastructure.  The overbuild of infrastructure led to plummeting costs.  The plummeting costs for access and for hosting as well as even more capital encouraged the development of a wealth of content.  Users helped by investing in their own modems and more graphic computers as well as shopping, gingerly at first, on the Internet and creating a wealth of content they value greatly – email.

The same thing happened with railroads.  Overbuilding led to plummeting transport costs (and a temporary decline in building railroads).  Lower transport costs enabled new industries which depended on cheap transport and couldn’t have existed without it.  The new industries meant more traffic.  Eventually the volumes generated enough revenue to make railroad building attractive again and another boom-bust cycle was kicked off.

“But,” the bubble-busters say, “most investors lose money in bubbles.  That’s bad.”

Unfortunately the benefits of capitalism do not include assured return on investment.  What is important is that the possibility of return leads to the availability of capital which funds development.  Most new businesses fail.  That doesn’t mean no new businesses should be started.  Total return to investors in the Internet or railroads or anything else adjusted for inflation may be less than zero.  What is important is that the total return to society as a whole is enormous. (If you’re a Luddite, you won’t agree.  Luddites should be against bubbles.)

Advances which change the nature of society require great sums of capital.  When that capital is available, it is available because investors believe that there is a possibility of great gain.  They are right about the possibility.  Some are delighted by the outcome.  Most are not.  But society as a whole benefits because the railroads or the Internet or whatever gets funded past the point of overbuild.  The result is plummeting prices, new uses, increasing volumes, even lower prices and new empowerment - whether it is the ability to get from place to place or access information world wide instantly.  These are the benefits of irrational exuberance.

“But,” the bubble-busters say, “this is just like a lottery.”

True enough.  Good analogy as a matter of fact.  People “invest” in a lottery even though they know it is a less than zero sum game because there is value to them in the possibility of an outsized gain.  From an economic point of view, we are willing to pay an “irrational” premium for the possibility of the outsized gain.  Call it a dream premium.

If a lottery is used to fund something worthwhile, is it a bad thing?  When the money “lost” to the participants builds a hospital, the game is only “less than zero sum” if your frame of reference is too narrow.

The Suez Canal was partially funded by an out-and-out lottery.  The money was raised.  The world benefited from goods which didn’t have to round Africa.

Historically, the results of bubbles have usually been more empowerment for more people.  Historically, bubbles have provided an explosion of funds which blasted away the entrenchments of an old oligarchy not only to the benefit of entrepreneurs but also to the benefit of consumers in general.  Think of the constantly falling price of transportation and communication.

If we should find a way to stop bubbles, if we were to put the genie of irrational exuberance back in the bottle, the winners will be whoever are the incumbents at the time and the losers will be all those who could benefit from another great breakthrough in infrastructure like railroads, canals and the Internet.

Bring on the next bubble.  And invest in it at your own risk. I will.

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