The Economy Needs a Bubble!

Nick Rowe, in Do we need a bubble?, states that economics generally assumes that “in a normal world, the equilibrium rate of interest [r] is above the growth rate [g] of the economy.” However, by this definition, our world is often and currently not in a normal state. With US inflation currently near 2% (core CPI) and the 10-year treasury bond yielding 2.2% (as of this writing), the real interest rate (risk free rate minus inflation) is just slightly positive. Meanwhile, nominal GDP in the 4th quarter of 2011 was 3.8%, meaning the real growth rate (nominal GDP minus inflation) is closer to 2%. (Note: Reported US data typically uses different rates of inflation for real GDP, but I used the same statistic here to simplify). When growth outpaces interest rates, the environment is ripe for borrowing money to invest and consume.

During these supposedly abnormal periods the demand for money is high. If this demand is not met with supply(e.g. through government deficits) or reduced (e.g. increased taxes), than people will seek out money-like instruments. Michael Sankowski notes that money-like instruments can be as simple as “stocks being used to purchase real world goods, or using the paper value of real estate as collateral to purchase real world goods.” Increasing demand for these instruments drives prices higher, which in turn, boosts their value as money-like instruments. This creates a self-fulfilling upward cycle in both demand and price. Therefore, “as long as the real growth rate is higher than the real interest rate, the economy will demand bubbles.” (Graph below from The supply and demand for bubbles (in pictures))

Americans experience during the past 20 years should bear out this fact since the economy has seemingly moved from one bubble to the next (e.g. dot-com, real estate, commodities). As we speak, stocks and commodities may once again be providing the bubble our economy desires. In contrast to the US experience, Japan’s economy has resembled a ‘normal’ world for much of the past 20 years. Deflation has largely kept the real interest rate (using 10-year JGB yields) in the 1-2% range, while real growth rates were frequently between 0-1%. This environment encourages reduced borrowing and, by extension, less desire for money-like instruments. The result has been real estate and equity markets that dropped over the entire period. (Graph from Dr. Housing Bubble)

While the economy may frequently desire bubbles, these are a sign of private sector waste (inefficiency) that always results in wealth destroying busts. Within Post-Keynesian schools of economic thought, both the interest rate and inflation can be controlled, to a degree, by the combination of fiscal and monetary policy. Accepting that our economy is often in an abnormal state is the first step to alleviating the economy’s need for a bubble.