The key things to know about the great American bubble machine

Summary: It’s increasingly obvious that the US economy has become locked into a low-growth, bubble-driven, boom-bust mode. This post provides a brief description, an antidote to the news media’s superficial coverage of this important dynamic. If readers are interested, future posts will provide a deeper analysis.  {1st of 2 posts today.}

Box of Bubbles

Contents

  1. Bubbles, bubbles, everywhere.
  2. San Francisco: America’s bubble factory.
  3. What pops bubbles?
  4. Is it different this time? Yes.
  5. Other posts in this series.
  6. For More Information.

(1)  Bubbles, bubbles, everywhere

The bubbles are everywhere. The best place to see them is on the pages of Zero Hedge, whose contrarian cynicism provides a good perspective for analysis of this madness; for example, see them dissect Tesla. Twitter’s results need no such analysis; they are self-explanatory, with its valuation (and executives’ pay) grossly disproportionate to its growth (and lack of profits). An earlier post looked inside the biotech bubble (spoiler: there’s nothing there).

Bubbles are consensual hallucinations. However absurd, we want to believe. We don’t look at internet advertisements, yet believe the stocks selling htem are like gold mines. We complain as the supply of internet advertising skyrockets — the “virtual economy” scrambling for money like a dying man digging for water at a desert mirage — yet we don’t see that the supply of net advertisements will always expand faster than corporations’ demand for them, and so ad prices will decline in price to the marginal cost of production (the virtual economy being too close to “perfect competition” for the hoped-for high profits).

Worse, the massive growth in social media traffic comes from underpricing its product. If investors forced these companies to price their products for immediate profits (as was the norm until the late 1990s), many would evaporate.

Worst of all, even the highest-quality internet advertising might not work well. So far companies ignore warning signs (see these articles in Quartz and in Slate).

So we naively believe. But the people blowing the bubbles are not naive.

 

(2)  San Francisco: America’s bubble factory

You do look, my son, in a moved sort,
As if you were dismay’d: be cheerful, sir.
Our revels now are ended. These our actors,
As I foretold you, were all spirits and
Are melted into air, into thin air:
And, like the baseless fabric of this vision,
The cloud-capp’d towers, the gorgeous palaces,
The solemn temples, the great globe itself,
Ye all which it inherit, shall dissolve
And, like this insubstantial pageant faded,
Leave not a rack behind. We are such stuff
As dreams are made on,

— Prospero in “The Tempest

I had a ringside seat at the first tech bubble, selling corporate services to early stage companies (start-ups to pre-IPO). In our conservative suits my partner (a grizzled veteran of Wall Street) and I would visit CFO’s in their shiny HQs. They would explain their business plan. These sounded to us like the Gnomes’ business plan from South Park (“Gnomes”, 1998):

Content & click, magic, profits! When we asked about Step Two, the reply was that “we didn’t get it.” Time proved they were right: we didn’t get it. Step two was sell the company’s stock to foolish investors and so get rich. Most of the CFO’s we spoke to profited handsomely from their ventures (less so their employees). Some got rich.

The San Francisco Bay Area has become America’s newest industrial center. The model is not manufacturing centers like bankrupt Detroit, cultural hubs like Paris, government cores like Brussels and Washington, or metropolitan areas like New York and London. The model is Hollywood; the product is dreams. The world sends money and receives stock certificates.

A large industry of venture capitalists, bankers, attorneys, and investment bankers has grown to support the Bay Area’s bubble machine, much like the somewhat similar machinery supporting 1930s Hollywood. Naive people survive only briefly in the New Economy.

Popping the bubble

(3)  What pops bubbles?

Bubbles are not Ponzi schemes, but have similarities to them. Both rely on supply of new marks to fuel growth (belief that there is always a “greater fool” to buy my shares). They pop when the supply of new capital diminishes — from exhaustion of existing sources and lack of new ones, or a decrease of investors’ risk tolerance (perhaps due to outside factors, such as recessions or geopolitical events).

They pop hard and fast when investors start to pull out capital (e.g., smart money or banks cashing out). Bubble investors are ruled by the prisoners’ dilemma: early defectors end the game, but profit most.

(4)  Is it different this time? Yes.

Investment bubbles are an inherent aspect of free market economic systems. They predate central banks, fiat currency and modern fractional reserve banking systems (despite conservative mythology). They leave both losers (chiefly investors and employees) and the infrastructure they built (e.g., canals, railroads, the Internet). The long-term benefits of this bubble are difficult to see. What does social media do for society?

The popping of previous investment bubbles caused recessions and depressions (e.g., the 19th century canal and railroad bubbles), because they relied on debt — much of it provided by banks. Almost every depression in modern western history (i.e., since 1800) featured a collapse of banks.

This time is different. The first tech bubble relied upon little debt, most of that being bonds (e.g., Global Crossing, Globalstar Inc). This bubble involves even less debt, so its popping will inflect only minor damage to the US economy (but severe hit to the Bay Area region economy). The real losses are opportunity costs, more damage from the financialization of the US economy: our scarce resources of capital and talent wasted on frivolous projects — while projects that could lay the foundation for a prosperous 21st century get ignored.

This would hit the credibility of the financial services industry, but its people are confident that American’s amnesia will again serve them — returning its customers to be harvested again soon. I disagree — a subject for a later post.

(5)  Other posts in this series about our bubbly economy

  1. Larry Summers gives us the bad news. Worse, the only solution is more of the same. –The necessity of bubbles for growth.
  2. Understanding the new world shown us by Larry Summers.
  3. The new tech bubble takes us to a new world. A mad world.
  4. Let’s ignore another warning from the BIS. Do we enjoy paying for burst bubbles?
  5. How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.
  6. We see a stock market bubble but prefer to close our eyes.
  7. Economics gets interesting as the economy darkens while stocks bubble.
  8. Don’t ask if there’s a biotech bubble. Ask why we have another bubble.

(6)  For More Information

If you liked this post, like us on Facebook and follow us on Twitter. See all posts about our great monetary experiment, about markets, and about financial bubbles, especially this about the benefits of bubbles: Will 21st Century USA have a surprise boom, as did the 19th Century UK?

For more about bubbles see these books:

 

 

26 thoughts on “The key things to know about the great American bubble machine

  1. Did I understand your argument correctly? When you state:

    “This bubble involves even less. So its popping will seriously damage the Bay Area region economy; the broad macro effects should be minor. ”

    Do you really mean:

    “This bubble involves even less. So while its popping might seriously damage the economy of the Bay Area region, the broad macro effects in the rest of the country should be minor.”

    There is one question that puzzles me in the present situation: what enduring infrastructure will the current bubbles leave behind exactly?

    Twitter and other social network companies will leave behind server farms. Very nice, but a large part of the hardware investment there tends to depreciate quickly, and all the programming may well end up as abandonware.

    Tesla? IPR, certainly, and a plant with depreciated machine tools and an unsaleable stock of cars and batteries.

    Biotech? IPR, and again, depreciated industrial equipment that will be scavenged by surviving producers.

    1. Guest,

      Thanks for pointing out this unclear text! You correctly interpreted it; I will fix it.

      As for the after-effects of this bubble — I agree, and will change the text. I was thinking of the first bubble, which greatly accelerated the tech infrastructure build-out: massive networks of fiber and servers, legions of trained software & communication engineers.

      What about this boom? The new drug discoveries are benefits (many would not have been developed except in a bubble), even if in aggregate the ROI of the bubble is low.

      We will end up with much more developed social media than we would otherwise have had (in a more rational investment climate). Who can say what this might mean for US and world society? It might prove ephemeral, a bigger version of CB radio. It might change society by linking us far more intimately together. We can only guess as to the answer.

  2. The state government here in California makes its numbers by taxing capital gains so when the music stops it won’t just be the Bay Area that tanks, it’ll be the whole state. As California goes so goes the nation is of course a truism.
    On a brighter note, there is a silver lining. My company, located in Emeryville Ca. Competes directly against GE. Time was, we lost jobs to them despite our better technology, and lean organization because GE finance was offering vendor financing to get the job. No more. GE is out of the shadow banking business and now we are like Hercules unchained, winning jobs easily. One irony, GE used to whisper to customers they should worry about our financial staying power when making buying decisions. Moody’s just downgraded GE’s corporate paper. Hopefully this kind of market rationalization is benefiting other scrappy little competitors too.

    1. Peter,

      “so when the music stops it won’t just be the Bay Area that tanks, it’ll be the whole state. As California goes so goes the nation is of course a truism.”

      I doubt every aspect of that. That a fall in the Bay Area will “tank” the whole State (it’s only 1/5 of CA’s population). That a recession in California would pull down the entire USA (its only 12% of USA population). The effect of regional downturns is often exaggerated — see the current hysteria by bears (e.g., Zero Hedge) about the effects of the oil bust.

      As far as capital gains tax revenue, I suspect it’s a far smaller part of total Federal tax revenue than in California. Income taxes were 46% of total Federal revenue in 2014.

    1. SDW,

      Thanks for mentioning that! US corporations have channeled an increasingly fraction of their cash flow back to shareholders as dividends and capital gains — and cut back on investments. Needless to say, that must slow growth.

      As usual, “why” is the big question. Perhaps its just another sign of the senescence of the US economy, as its elites prefer to consume as much of our income as they can — and no longer care as much about growth.

      By the way — the Bloomberg analysis, like most such, is wrong on one key aspect. Corporations are furiously buying back stock, even borrowing to do so (leverage at US corporations has increased since the crash, and the debt is not being spent on capex) — but the sharecount is not dropping accordingly. Much of buybacks are part of the new triangle trade: executives exercise stock options +> corporation issue more publicly traded shares => corporations buyback the shares. The net effect is a shift of cash from the company to the executives, on a scale never before seen. That’s how all those executives wind up billionaires. To understand the buyback I strongly recommend reading FactSet’s Buyback Quarterly.

      General Accepted Accounting Principles (GAAP) require this to be counted as an expense. But corporations, their accomplishes (Investment Bank annalists), and their useful idiots (aka financial journalists) all pretend otherwise.

      It’s part of the looting of America. The history of this time will be titled “At Dawn We Slept: the untold story of the birth of New America.”

  3. Nice expose of the phenom of Stock Buybacks. And off shored profits just sit while these Companies lever up at ZIRP for such willful shenanigans.

    Question:
    What exactly was the nature of the Corp Services you and your partner were trying to sell to these CFOs?
    (The answer will help me more clearly understand the Gnomes!)

    Breton

  4. As you might imagine, the San Francisco tech bubble is an oft debated and hotly contested topic.
    One thing I notice, it seems many people underestimate the value that is created by the technology sector in general, which goes well beyond simple social media and advertising, into things like database and enterprise management, business systems, and lately, robotics.
    But still, although PE ratios and cash balances for these kind of companies look much healthier than they did 15-20 years ago, a lot of valuations have definitely ventured into Crazy Town, particularly for some private equity. I do think the goal for a lot of these new startups is to cash out before they crash out, so to speak.
    I’ve heard most people assume we’re in a bubble, in several senses of the word, and it seems the consensus estimate is for a crash is within 1-3 years, perhaps to coincide with the Fed’s anticipated rate-tightening.
    Yes, when that does happen, I’m happy it will leave the infrastructure, both public, private, and human. The shiny new apartment buildings, the upgraded roads and trains, and the people who know how to write software and manage business will all still be around, even if they are no longer worth as much as they used to be.
    The previous crashes hit the rest of the country much harder than they did the Bay Area, perhaps partially because of that infrastructure. I’d like to hear more details on why Fabius Maximus thinks this time will be the reverse.

    1. Todd,

      This was, as described, a brief look at a complex phenomenon — so only touched upon the high points. I don’t believe you understand my key point: it is a bubble not primarily because of valuations — but because investment flows have created so many businesses which cannot survive without inputs of cash. It is stage three of the Minsky cycle.

      “The previous crashes hit the rest of the country much harder than they did the Bay Area, perhaps partially because of that infrastructure. ”

      I do not understand what you are saying. We have had one prior tech crash — in 2000, in which the Bay Area was hit harder than the U.S. average.

    2. Editor
      “We have had one prior tech crash — in 2000, in which the Bay Area was hit harder than the U.S. average. ”
      As always, you remind us that it’s important be specific when talking about economics. I was talking about the two big economic crashes of the 21st century, the one in 2001, and the other one in 2008. Perhaps I spoke too boldly about the relative regional effect of these crashes. After reviewing a few metrics, I can see that the Bay Area was in fact hit harder in some, such as unemployment rate. In others, such as per capita income and housing prices, it was mixed or better.

      “my key point: … investment flows have created so many businesses which cannot survive without inputs of cash”
      I do not disagree with that.

      By the way, good to bring up Minsky here. I think people have forgotten about him lately, to their own detriment.

    3. Todd,

      The 2008 crash was not a tech crash, it was started by a real estate bubble. California was hit harder by most metrics than most states because its RE bubble was bigger than most.

      The 2000 recession was started by a tech bubble bursting. But it was by far the lightest recession since the 1930s (when accurate records begin), with the 3 quarters being -1.1%, +2.1%, -1.3%. Note that it doesn’t meet the layman’s definition of 2 sequential down quarters. It also hit California harder than most States.

  5. “I doubt every aspect of that. That a fall in the Bay Area will “tank” the whole State (it’s only 1/5 of CA’s population). That a recession in California would pull down the entire USA (its only 12% of USA population)”

    I doubt every aspect of that, in heavily interconnected networks, markets, economies, systems, even the right 1% failing brings down the whole, you can bring down the whole US power system by taking down 1% of the infraestructure, and you can take the US economy down by taking down the right few crucial economic systempunkts,

  6. “I do not understand your comment. The words are vivid, but unclear. Most important, what do you mean by the metaphor “bring down”?”

    My comment is very clear, you made an analisys mistake, everybody makes mistakes. It demonstrates you are human. What do I mean by “bring down”? I mean like collapse, structurally fail, rapidly decay.

    1. Salacious,

      “I mean like collapse, structurally fail, rapidly decay.”

      What is your evidence for this belief? Modern western economies (since 1800, or perhaps 1850) have had many depressions, some 5-10 years long. Offhand I can’t recall any that “brought down” the economy in a major developed nation, in your sense of the term. Depressions are just cyclical events, the normal boom-bust pattern of growth. Summer then winter, slowly growing over time.

      Wars have done so, but by destroying a lot more than 1% of infrastructure. Plagues have afflicted more than 1% of populations, sometimes even killed more than 1% — but not “brought down” a major nation.

      Revolutions are another complex event, but too far afield to apply here.

  7. “Revolutions are another complex event,, but too far afield to apply here.”

    Right, says the Editor of the blog with Don and Chet as authors, how should write here so that revolutions are not too far afield Hakim Bey?? Give me a f*****king break.

    1. Local,

      “too far afield”

      I write focused articles to help people understand specific questions. So political revolutions were “too far afield” from a discussion about cyclical and secular economic trends as explanation for the current bubble in the US economy.

      “with Don and Chet as authors”

      Neither have written anything about this phenomenon.

  8. “I write focused articles to help people understand specific questions.”

    Things cannot be understood whentaken out of context.

    1. Local,

      I suggest you try writing these before giving such rude criticism. Only so much can be said in a thousand words (after which traffic drops off quickly), without broadening the scope so it becomes a series of Hallmark Greeting Card text. Setting boundaries on the subject is the first and most important step.

  9. Editor,
    His website is not active right now, andyou claim to care about the future of America, I can clearly help to bring clarity, if you would only give me a chance. Take a leap of trust.

  10. Absolutely superb article. Aside from being hilarious (the gnomes’ “business plan”), your post touches on the whole issue of secular stagnation raised by Larry Summers — which, if true, suggests that the U.S. economy now requires an endless succession of bubbles merely to supply full employment.

    That’s not sustainable, methinks.

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