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July 1, 2007
David Warsh, Proprietor


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The Upside of Bubbles

Towards the end of his life, the economist Charles P. Kindleberger tumbled with great excitement on to One Hundred Years of Land Values in Chicago, by Homer Hoyt. Published in 1933, Hoyt’s book traced in great detail five cycles of boom and bust in the Windy City, starting with the huge run-up in land prices that accompanied the railroad boom of the 1850s and 1860s, which set values that in some cases were not seen again until the end of the 1920s, so stubborn was the resolve of speculators to see their bets pay off.

In 1871, according to one Chicago writer, “every other man and every fourth woman had an investment in house lots” — properties they were determined not to sell at less than their hoped-for profit, much less at a loss, unless taxes and interest rates ground them down. The lesson that Kindleberger took away from Hoyt was that in boom times, speculative markets rise together, but they lose their steam at very different rates. He wrote real estate into the third edition (1996) of his classic Manias, Panics, and Crashes: A History of Financial Crises. Expect a downturn in real estate to follow a stock market crash, but with a substantial lag.

Perhaps the best way of understanding today’s jitters over sub-prime mortgage lending is as an aftershock from the tech bubble of 2001 — not the start of something new but the threatened unwinding of positions taken by investors who now must deal with a hangover from a bout of euphoria — balloon payments, negative equity and so on.  If that’s the case, the crisis can be expected to resolve without the painful meltdown of various injudicious banking institutions that, for now at least, remains a real possibility.

The standard response will unfold. Federal banking regulators will tighten up, mortgage bankers will act more cautiously, and the hedge funds who bought a dizzying array of collateralized debt obligations will scramble to devise new market mechanisms to assess the real worth of their portfolios. Meanwhile, far removed from the spotlight, others will be setting in motion the new technologies and financial tools that eventually will enable the next great craze.

Not a bad time, therefore, to take a longer view of the process. Two books have appeared this summer that shine some light on the time-honored propensity of markets and governments to overdo things: Pop:  Why Bubbles Are Great for the Economy, by Daniel Gross; and Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Capital Markets, by Philip Hoffman, Gilles Postel-Vinay and Jean-Laurent Rosenthal.

Now I’m a journalist and I like journalism. Gross is a peripatetic newsman, having written for Slate, The New Republic, New York, Wired and The New York Times. He has a good solid grounding in the work of professional historians, as well — a master’s degree in history from Harvard University and a collaboration with Davis Dyer that produced Generations of Corning: 150 Years in the Life of a Global Corporation, 1851-2000.

So Pop is a beguiling read, well-informed and shrewd in its judgments.  Gross’s argument is that bubbles are the result of an essential aspect of American character, that the US government often has had a hand in making them happen, and that they can be useful when they leave behind a commercial infrastructure that others can use.  There are snappy chapters on the history of the telegraph, the railroads, the financial New Deal (meaning the “set of regulations, insurance schemes and government backstops” that were created to restore confidence eroded by the stock market Crash of 1929 and subsequent Depression), the Internet, real estate and alternative energy (his nominee for the next new thing). 

If the conclusion sounds as if it was written to be performed by movie star Tom Cruise (“When it comes to business, the United States is like a shooting guard, who, heedless of the air-ball he hoisted a minute before, stands twenty-three feet from the basket and demands the ball as the clock ticks down. Excess confidence? A lack of awareness of one’s limitations?  Sure.  But it also signifies an ability to not let recent failure stymie new efforts”),  the book itself is still better than average magazine writing. And that is precisely where Gross has pitched his tent and staked his claim.  While keeping his weekly “Moneybox” column at Slate, he is adding a bi-weekly column in Newsweek, replacing the venerable Allan Sloan, who has moved to Fortune.  Good news for those of us who value running commentary.

Surviving Large Losses is a very different sort of book. The authors are distinguished economic historians, Hoffman and Rosenthal at the California Institute of Technology, Postel-Vinay at the École des Haute Études en Sciences Sociales in Paris.  Despite its slim size (258pp.) and apparent lack of formal methods, theirs is a deeply serious essay — a worthy companion to Kindleberger’s book, perhaps even an alternative to it, inasmuch as its treatment is less descriptive and more analytic of the political economy of crises. These authors, too, believe that it makes sense to look past the headlines — “global credit woes” — for the deeper evolution that is taking place. They find their explanations in the strategic situations facing various players in the drama — politicians, investors, business folk, global lenders — and in the institutions that guide and proscribe their conduct. 

Financial crises may be a hardy perennial, the authors note, but they come in many shapes and sizes (crises defined simply as occurring whenever a large number of contracts are broken). The government of the United States routinely undertakes bailouts to make certain that large losses do not occur, bailing out banks, pension plans, even hedge funds such as Long Term Capital Management, in order to make certain that its citizens do not suffer large losses. Yet the governments of other nations — Germany, memorably, in the 1920s; Argentina in 2001 — default on the debt they owe their citizens, freeze bank accounts or devalue the currency, which has the same effect, of imposing large costs on investors. Why the difference?

The authors trace it back to the origins of public finance in Western Europe, 500 years ago, when monarchs learned to borrow from bankers to meet emergency expenses beyond what could be raised in taxes. Such public debt turned out to be a blessing, nurturing capital markets and stimulating growth (often mainly by fighting wars), unless the debt became too great. At some point, governments would default on their obligations, imposing large losses on lenders and stimulating the search for means of preventing a repetition.  The idea of a “danger zone” is introduced — an imprecise but thoroughly recognizable threshold of indebtedness at which the temptation to default rather than repay would become irresistible.

Three big innovations have been introduced over the centuries, designed to permit nations to escape from the trap of repeated default.  One is simply the idea that the level of public debt must be manageable, relative to the tax revenues government expects to receive.  (This magnitude of an acceptable limit may vary greatly according to the customs of the nation in question, of course.) Another is the recognition that sufficient financial information must be available to inspire confidence among would-be investors — usually but not always mandated and enforced by governmental authority.

Finally, a large and powerful middle class is the most reliable guardian of good conduct by a state; almost invariably that has meant democracy. These broad institutions have evolved in response to periodic financial crises over the last several centuries, the authors say. Their effect has been to diminish both the frequency and amplitude of crises, and the sudden losses imposed by accident and design by unsuspecting wealth-holders.

The excitement of Surviving Large Losses is not easy to convey. It is a different kind of thinking cap, that’s all. On every page it reflects the substantial changes wrought by political economists during the past thirty years or so in the way we understand the sources of the wealth and poverty of nations. It delivers a profoundly optimistic message, however — that eventually we get wise to ourselves; that gradually financial knavery is reduced; that by learning from our mistakes we are creating a more stable financial order, and perhaps even a more just world. 

The authors end on a somber note, considering the mounting tensions between population growth and expectations of the welfare state, both in the industrial democracies and the developing nations. But even here, the upside of crisis is apparent. Is there an “entitlement” bubble?  Must the dream of the middle class be written down, at least for a generation or two? Perhaps nothing more than a haircut will be required. The moral of Surviving Large Losses is that what doesn’t kill the capital markets makes us stronger.

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