A Contrarian view on Bubbles
Updated: Feb 2
A Contrarian view on Bubbles
Written by: Zheng Yuxiang
Are bubbles really that destructive?
A widely adopted view on speculative bubbles is the view that bubbles are socially destructive and economically inefficient. Examples of economic bubbles in history ranged from the Tulip Mania in 1637 to the United States housing bubble in the 2006-2007. The United States housing bubble is one example of a socially destructive bubble, a testimony of the global adversity resulting from the burst of a bubble exacerbated by the interconnectedness of the modern financial system. The valuations of securities tied to the United States real estate plummeted, adversely affecting the financial institutions such as Lehman Brothers (Altman, 2009). Lehman Brothers was eventually declared bankrupt on September 15, 2008. As a result of the financial crisis, the United States Federal Reserve ended up purchasing US$2.5 trillion of government debt and troubled private assets from banks (Altman, 2009).
Deeper dive into the mechanics of a bubble
Borrowing the definition from Charles Kindleberger, an economic historian who wrote the book “Mania, Panics, and Crashes”, about speculative stock market bubbles. A bubble can be described as an “upward price movement over an extended range that then implodes” (Kindleberger, 1978). The reason why bubbles start could be attributed to two reasons. The first being government policies. For example, the desire of governments wanting to increase levels of homeownership resulting in housing bubbles (Quinn & Turner, 2020). Secondly, technological innovation can start a bubble as firms that use new technology generate abnormal profits, thereby resulting in an increase in valuations and capital gains.
The increase in capital gains attracts momentum traders who buy shares due to increasing share prices. The high valuations usually remain for two reasons, first being the relatively new and unknown technology to which the economic impact is uncertain. The lack of information available makes it difficult to value the shares accurately. Second being the fact that anticipation surrounding the technology results in elevated levels of media coverage drawing in further investors. Not to mention, the new narrative of a technological era that the new technology is potentially world-changing thereby rendering the old valuation metrics obsolete, justifying its high prices (Quinn & Turner, 2020).
Experts’ view on bubbles
Referring to the work of Markus Brunnermeier, an economics professor at Princeton University. Bubbles can be toxic and destructive when investment in new areas is fuelled by debt. He finds that the severity of the economic crisis following the bursting of the bubble is more linked towards the financing of the bubble rather than the type of assets. In his words, “Crises are most severe when accompanied by a lending boom and high leverage of market players, and when financial institutions themselves are participating in the buying frenzy” (Brunnermeier & Schnabel, 2016).
On the other hand, Brunnermeier claims that bubbles are not necessarily bad things as they can drive investment into ripe and new areas of the economy. In his words, “Without the bubble, some things would never get off the ground.” The formation of certain bubbles therefore can be thought as an important process to drive investments into certain domains (Brunnermeier & Schnabel, 2016). Evidently shown as some financial bubbles allow for deployment of financial investments to fund disruptive technologies at the frontier of innovation, at the same time accelerating breakthroughs in science, technology, and engineering.
Bubbles as a means of financing innovation
In fact, quite a few researchers have agreed, a research paper by Ramana Nanda and Matthew Rhodes-Kropf, “Financing Risk and Innovation”, concluded that financial market activity is not purely a response to novel technologies and suggested that financial markets drive innovative activity. The research paper then went on to argue that innovative new ventures require ‘hot’ financing environments to help with their initial financing or diffusion (Nanda & Rhodes-Kropf, 2017). By driving experimentation, financing risk may play a key role in creating and magnifying technological revolutions and the process of creative destruction.
Figure 1: Funding for AI Startups
Source: PitchBook (U.S., rest of world data); Tsinghua University — 2018 China Artificial Intelligence Report (China data); BCG Center for Innovation Analytics; BCG analysis
In fact, looking at recent technological trends, such as Artificial Intelligence, between 2012 and 2018, there is a staggering $110 billion into 9,800 AI start-up rounds of financing. There is indirect evidence to suggest the frothiness of a bubble. The frequency of mentions of “Artificial Intelligence” during earnings calls skyrocketed around 2015, the mentions increased tenfold between 2015 and 2017, the rate of increase exceeds the growth of artificial intelligence applications (Gerbert & Spira, 2019). Considering the financing of artificial intelligence companies, it will likely alter the economic trajectories of various industries.
Going back in history to 1942, Joseph Schumpeter an economist overshadowed by John Maynard Keynes first coined the term “Creative Destruction”. Former Treasury Secretary Lawrence Summers and his ex-deputy Bradford DeLong, observes that “the economy of the future is likely to be primarily ‘Schumpeterian.’ (DeLong & Summers, 2001)” Joseph Schumpeter coined the term ‘Creative Destruction’ which describes an economy where innovation is the principal source of wealth. Companies that innovate tend to require quite a bit of investment initially but very little to keep it going.
Figure 2: Schumpeter's Waves of Innovation
Source: The Natural Edge Project
Given the incredibly high valuations of some tech companies and the monetary policy easing in recent times, concerns about a financial bubble have intensified. Ultimately, I believe that a collective over-enthusiasm regardless of economic or social bubbles seems to be a necessary process to create a collective attitude towards risk taking, breaking the stalemate of society that is restrained in a tendency towards risk-avoidance. I believe that by allowing innovative ideas to be progressively adopted through a wave of positive feedback loops building enthusiasm without much concern for risks this would inadvertently build up new innovative technologies that would bring about much positive impact on society.
Altman, R. C. (2009, January/February). The Great Crash, 2008. Retrieved from Foreign Affairs.
Brunnermeier, M. K., & Schnabel, I. (2016, May). Central Banks at a Crossroads: What Can We Learn from History? Retrieved from Cambridge University Press.
DeLong, J. B., & Summers, L. H. (2001). The ‘New Economy’: Background, Historical Perspective, Questions, and Speculations. Retrieved from Federal Reserve Bank of Kansas City.
Gerbert, P., & Spira, M. (2019, May 15). Learning to Love the AI Bubble. Retrieved from MITSloan.
Kindleberger, C. P. (1978, July 2). Manias, Panics, and Crashes: A History of Financial Crises. Retrieved from Basic Books.
Nanda, R., & Rhodes-Kropf, M. (2017, April). Financing Risk and Innovation. Retrieved from Harvard Business School.
Quinn, W., & Turner, J. D. (2020, August 6). Boom and Bust: A Global History of Financial Bubbles.Retrieved from Cambridge University Press.