New Paradigm Investing
Why Bubbles are Good

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By XaosSurfer
July 31, 2002

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The economic bears believe that the economy is headed into a long and difficult recession. In their minds, we must pay a price for the economic boom and the bust will match the length and magnitude of the boom. They assume the economic boom and the Internet bubble was a terrible mistake, caused by misguided monetary and fiscal policies. This argument misses the core functioning of the American economy: it is not simply cyclical but it is dynamic - always moving forward into the future. Far from a policy mistake, the technology bubble was a necessary, normal and healthy event in the progress of the economy.

In order to analyze bubbles we must identify the type of the bubble. There are three types of bubbles:

- asset bubbles
- technology bubbles
- structural instability bubbles

Asset bubbles are when the price of a particular class of asset uncouples from it's economic value and rises to very high levels, driven by an investment mania. The infamous Dutch Tulip Bulb bubble is an example. The Japanese land bubble in the '80's is another. The key is that these bubbles leave nothing of sustained economic value behind. This is the type of bubble the Austrian school of economic analysis describes.

Technology bubbles happen when a radical technology emerges that has the potential to transform the economy, society and politics. The bubble / crash itself is driven by exactly the same mania that drive asset bubbles. The difference is, at the end of the bubble there is much left behind (technology, knowledge, social practices, infrastructure) that has economic value. Technology bubbles increase the wealth creating capacity of the economy.

Structural instability bubbles happen when non-economic events impact an industry that cannot absorb the shock. An example of this is the oil services industry. There is instability because of the operations of OPEC and the political instability of the region. This can cause oil prices to rise/fall with no underlying increase/decrease in demand. The DRAM industry has had structural instability bubbles as well. I suspect that the US S&L bubble was like this as well.

Not all bubbles are alike. However, they are all driven by investment manias so the last half of the bubble and the whole crash all look very similar. It is what happens after the bubble where the type of bubble matters. Technology bubbles are good for the economy. The fact that 12 of the 14 technology bubbles since the Industrial Revolution have happened in America is not a coincidence and should be celebrated.

It is often claimed that turns in the stock market are early predictors of booms and recessions. In much the same way, technology bubbles are early indicators of radical transformations in the economy, society and politics. Each of the 14 technology bubbles I reviewed led to significant changes in the way societies operate. Each bubble ultimately led to an increase in the standard of living for that society.

There are three dynamics underneath the formation of technology bubbles:
- the new technology is radical, it operates at the foundations of the economy and society;
- no one knows how to apply the new technology profitably; and,
- a shared infrastructure is required.

Two other things must be true - the economy is healthy and interest rates and inflation are low.

If you put these five ingredients together in any country in the world, except the USA, you will get a very slow process that attempts to understand the risk and dangers of the new technology, people will study various deployment strategies to see how the technology might be made profitable, and a few hundred feasibility studies would be undertaken to sort out how to build the shared infrastructure.

Mix those ingredients in the USA and all hell breaks lose. Entrepreneurs grab some of the cheap money and start to build. Instead of a careful evaluation of the new technology, a brutal version of Darwinian capitalism is unleashed.

I think of the beginning of this period as the start of a marathon with each runner represent one idea about how to move the new technology forward and build the shared infrastructure. The runners are told the course is 26.2 miles long and that water tables have been set up every half mile over the course. Of course, this is too much and some of the runners over-indulge and quit the race. Then the tables are set up a mile apart. This is just fine and all the remaining runners are well hydrated and fed. Then, at mile 13, a cruel joke is played on the runners. No more water tables for the rest of the course. Sorry. The runners start to drop out the race rapidly. At the end of the race, the only runners left are the ones that were strong enough to stay the course.

It is a giant experiment. At the end of the experiment there are several outcomes. The best technologies are left standing. The holes in the technology have been fixed. A few companies have figured out how to use the technology to make money AND, this is the most important, the shared infrastructure is built. This is important and it happens to some degree in every technology bubble. The fact is, that there is never a sufficient economic justification for building the shared infrastructure. The capital required to build and maintain the canals, railroads, telegraph, road system, hydro grids, rocket pads, satellite tracking, TV and radio infrastructure - never pay back their invested capital even though the infrastructure is crucial for the success of the technology.

It seems that American capitalism has found an accelerated and efficient method to quickly mature new radical technologies and build the shared infrastructure needed to make the technology productive. This process is far from rare. It has happened at least 12 times since 1840, about once every 15 years. Bubbles are not all the same magnitude; the railways and the Internet were the two largest, by far.

Bubbles build the shared infrastructure needed to make radical technologies profitable when there is no economic incentive for any group of investors to build that infrastructure. The economic pay back begins at the bottom of the crash, when entrepreneurial businesses start applying the technology and infrastructure to make their businesses orders of magnitude more productive.

Who knew when the railway was being built that Mr. Sears would start selling household goods through the stationmasters at the new railway stops. Business picked up to the point that he needed to print a catalogue to help them keep track of the merchandise.

Who new when TV was first invented that it would be the final piece in the mass production value chain. The ability to communicate directly to a mass market and convey the message of your product was essential for starting the mass production boom of the '50's and '60's.

The economic capability - the wealth creating capability - left behind after technology bubbles is awesome. All that is needed is for the entrepreneur and innovator to apply them and transform their industries. Bubbles aren't pretty but they work.

People talk about the Internet Revolution or the Information Revolution. Both are very limited interpretations. As Peter Ducker continues to remind us, we are at the crux of the Knowledge Revolution just as the railways were the crux of the Industrial Revolution.

The 'business mistakes' of the past seven years were not mistakes at all. We have not been left with an over-capacity of fiber optic networks that we need to burn off. We were left with a shared infrastructure that we are just know learning how to use.

As always, Schumpeter's [Biography] "Gales of Creative Destruction" are blowing through the economy moving capital for unproductive assets and processes to more productive ones. We are just at the beginning of the revolution. Please fasten your seats belts and keep your hearts and minds wide open. It will be one heck of a ride.

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