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August 21, 2007

In Defense of Bubbles

The press is full of stories of people who’ve been hurt by the housing bubble, people who borrowed too much and now face losing their homes because both the housing bubble and the sub-prime credit bubble are – not coincidently – ending at the same time. What’s missing from the press I read are stories of people who bought homes before the bubble, didn’t refinance extravagantly or sold and took profits, and now have a nice nest egg. What’s also missing are the stories of people who got credit even though they would not have qualified previously and now own partially-paid-for homes as a result.

There is no question that there are families in real trouble because of over-easy credit. There is no question that lenders and those who finance them got greedy and extended credit they never should have extended. There may be a social purpose in helping some of the former; there is no social or economic reason to help the latter. It would be bad policy to do so.

But we don’t want to eliminate future bubbles; bubbles do more harm good than good harm.

You wouldn’t believe that assertion if you read the story in this morning’s NY Times about American’s adjusted growth income from 2000 to 2005 headlined 2005 Incomes, on Average, Still Below 2000 Peak. The story contains this dismal graph:

Sure enough, if you measure from peak year 2000 when there was a huge stock market sell off (meaning many, many people were taking gains even if they weren’t selling at highs), you find that adjusted gross income (inflation adjusted) hasn’t recovered.

It took a little work since The Times didn’t deign to give URLs of its source; but I went back to IRS reports that describe the period covered in this graph (http://www.irs.gov/pub/irs-soi/05intba.xls and http://www.irs.gov/pub/irs-soi/01intba.xls) and extended back in time to get some perspective (http://www.irs.gov/pub/irs-soi/97ina.xls). The resulting graph tells a different story:


Incomes started to rise rapidly in the late 1990s as the bubble got underway. They did collapse FROM THEIR HIGHS as the bubble burst; they never fell back to the pre-bubble level (inflation adjusted) of 1996. If anything the bubble seems to have spurred a faster long-term trend in income growth (but this graph alone doesn’t prove that). It’s a fact that the bubble of late 1990s paid for the infrastructure on which the Internet has grown.

And, with hindsight, I think we’ll find that the housing bubble financed a permanent upward bump in the balance sheet of many American families AND made home ownership – continued home ownership possible for people lenders would have turned away.

Snarky notes for math nerds: when you put numbers together from different sources and double-check them, you find funny things. The NY Times (or its unnamed source) think that $7,422,495,663,000 (total US AGI in 2005) rounds to $7.43 trillion. The IRS incorrectly inflation-adjusted AGI for 1997 in some of the spreadsheets cited above (I corrected).

The first post ever on Fractals of Change was about the great Internet bubble and the reason why this blog’s motto is “nothing great is ever accomplished without irrational exuberance”.

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