Wednesday, April 27, 2011

The value of Bubbles

Great article in Bloomberg BWeek this week (4/18-4/24 issue) by Peter Coy. The gist is that financial bubbles can be good or bad. I always that this was true depending on who you are. If you are employed in the sector, you take your money home with you. If you sell before the bubble bursts, then you get a good (although perhaps undeserved) return. But if you are stuck holding shares when the music stops, you lose your shirt.

But they divide it up another way also. It depends on part on what is being bought and sold. If it is something with durable value, then the bubble can be good for society. The tech bubble created a lot of dotcom crashes, but also a lot of bandwidth all over the world that was eventually exploited by Amazon, Google, YouTube, etc.

If it is something that keeps a constant value, then it just transfers money from bad investors to good investors. For example, trading in gold right now. If you buy it at $300, sell it to me at $1500, and then I have to sell it later for $300, there is still an ounce of gold sitting in a vault somewhere. No net net change on society except for the temporary stress on the economy if the bubble is a big one.

It's when the bubbling asset loses value that bubbles really hurt. All of the extra housing that was created in 2000-2006 is the wrong size, in the wrong place, and getting moldy. So in addition to the short term stress on the economy, there is also a loss of real value in the asset. These are the bubbles that we really have to watch out for, and that perhaps Central Banks around the world should prick early.