Why bubbles are great for the economy.

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Illustration by Mark Alan Stamaty. Click image to expand.

If you blew the kids’ college fund on stock back in 2000, or dropped $800,000 last year on that spec house in Phoenix that you knew you could flip for $1.4 million, you probably won’t believe me when I say: Investment bubbles are great for the economy. Yes, those periodic outbursts of investor insanity, which inevitably degenerate into venality, corruption, and searing losses—America needs them!

In my new book, Pop! Why Bubbles Are Great for the Economy, I explain why Americans have misunderstood the frenzies, manias, and stampedes that periodically seize us. In that magical world known only to a few economists, where resources are allocated efficiently and investors and consumers behave rationally, bubbles would always be unambiguously negative. They cause all sorts of distortions and silly, self-defeating behavior (buying at $400). But that’s not the world in which we live, especially in the United States. We are not blessed with a population composed entirely of hyper-rational individuals. And the government doesn’t control the deployment of revolutionary inventions. As a result, new technologies and ways of doing business are always rolled out in fits and starts. What’s more, the excitement of a new technology interacts with some of the more unstable components of America’s character—boundless optimism, a tendency toward entrepreneurship, a tolerance of creative destruction, and greed—to produce a kind of mania. So, every time a hot new technology comes along (whether it’s the telegraph or the Internet), Americans collectively lose their minds—and then lose their shirts.

Looking back through the last 150 years, a familiar pattern emerges. A wonderful new technology or economic idea arrives. A few good years of solid growth help engender a sense that things are different and that new rules apply. Hype and rosy projections—from Irving Fisher’s 1929 prediction of a “permanently high plateau” to Dow 36,000­—justify investing at stratospheric levels. The trend, previously confined to the business community, crosses over into popular culture. Everyone’s buying stock, investing venture capital, refinancing a mortgage, installing compact fluorescent light bulbs. And then, pop! The bubble bursts, heroes become goats, and bankruptcies spread. As corruption and venality are exposed, self-loathing and recriminations rule the day. (See: subprime lending, spring 2007.) And that’s when all the moralizing narratives about the tragedy of bubbles get written.

But this is only half the story! After all, the process of growth and innovation doesn’t end when a bubble bursts. The Internet wasn’t unplugged and shut down in 2002. In fact, once you gain a little historical distance from bubbles, it is clear that some bubbles—some, not all—leave behind something that is a little bit boring but extremely useful: infrastructure. The bubbles that have left behind commercial infrastructure have been incredibly important contributors to America’s remarkable long-term economic performance.

Simply put, bubbles are how new commercial infrastructure gets built in this country. In the 1840s and 1850s, European governments slowly strung up telegraphs from large city to large city. But in the United States, bubble-drunk entrepreneurs rampaged throughout the countryside, stringing up competing and often redundant wires way ahead of demand. Most went bankrupt. In the 1880s, vast competing, and often redundant, rail networks were built way ahead of demand. By 1894 about a quarter of the rails were in bankruptcy. The 1990s saw an orgy of commercial infrastructure built for the Internet. We all know how that ended.

But Americans recover from failure very quickly. All that infrastructure wasn’t torn down—it was consolidated, taken over by new investors with lower cost bases, and reused. The cheap, pervasive telegraph led to American dominance in the national and international market in information—and long-lasting businesses like the Associated Press and the Chicago Board of Trade. The cheap, pervasive national railroad network led to an integrated market in goods and commodities—and long-lasting businesses such as department stores, mail-order retailers like Sears, and national brands from Coca-Cola to Procter & Gamble. The Internet pop has left us with Web 2.0—Facebook and Skype, MySpace and YouTube, and, most of all, Google. Each of these companies either was started or gained critical mass after the Internet bubble burst. Each gained tremendous scale overnight thanks to all the cheap excess capacity built during the 1990s bubble.

During bubbles, a second type of infrastructure is built, too: the mental infrastructure. The money raised during bubbles doesn’t just go into the incinerator. It is spent on marketing, advertising, promotion, hype, and brand awareness. Bubble-era companies, desperate for traffic, discount furiously, pay rebates, offer free shipping, and run their businesses on negative margins—all as part of a heroic effort to coax consumers and businesses to spend their money in fundamentally different ways. The telegraphs slashed per-word rates to compete with the mail and with each other. The railroads slashed freight rates to compete with canals and rivers, and with each other. In the 1990s, the entire e-commerce sector spent furiously to persuade consumers and businesses to take the leap of faith and buy stuff—stocks, books, airline tickets, pet food, groceries, diamonds, chemicals, you name it—online.

Most of the pioneering Internet bubble-era companies failed as businesses. But they succeeded in making millions of people believe that it was safe, efficient, and desirable to conduct business online. That mental infrastructure didn’t disappear after the bust. People didn’t suddenly stop buying things online in 2001. According to Forrester Research, e-commerce more than doubled between 2001 and 2006, to $211.4 billion. Post-bust innovators were able to tap into both a commercial physical infrastructure (near-universal broadband) and a huge installed base of customers. Thus, businesses that were stillborn during the boom (Webvan, advertising-supported video sites) can thrive after the bust (FreshDirect, YouTube).

Today the services-driven U.S. economy is showing a remarkable capacity to blow and deflate bubbles quickly. With the assistance of Federal Reserve Chairman Alan Greenspan, we transitioned seamlessly from Internet bubble to real-estate bubble to alternative-energy bubble in just six years. That makes the mental infrastructure more important than ever. Take the housing bubble that just popped. Millions of people will get hurt—and hurt badly—as housing prices fall and ARMs are reset higher. The upsides of bubbles are always hardest to see when things are collapsing. (Raise your hand if, in 2001 and 2002, you thought an Internet search and advertising company would be worth $146 billion in 2007.) But the mental and commercial infrastructure surrounding real-estate credit will remain. The culture of refinancing, which proved a huge boon to the economy throughout the 1990s and first half of this decade, will stay with us. So, too, will important bubble-era services like Zillow that empower consumers.

These efforts to make a virtue out of some of the worst tendencies in the American economic character may sound like a naive exercise of hope over experience. But in my book, experience should give us hope—even if the housing bubble continues to wreak damage on the economy and the alternative-energy space is getting bubbly.  It is possible, even rational, to be both short-term gloomy and long-term optimistic. Those who believe that the nation’s experience with bubbles is all gray cloud and no silver lining need to ask where we would be without the irrational exuberance. Without the disasters of Global Crossing and Worldcom, would we still have Google?