Throughout the history of capitalism, economic bubbles have been commonplace. They have emerged wherever liquid financial markets exist. The range challenges the imagination: from the iconic tulip bulb bubble, to gold and silver mining bubbles, to bubbles around the debt of newly established countries of unknowable wealth, to -- again and again -- real estate and stock bubbles.
The central dynamic is always the same: The price of a financial asset becomes detached from the real value of the economic asset it represents. So the price of dotcom shares in 1998–2000 soared out of any relationship with the underlying cash flows -- present or future -- of the startup companies striving to exploit the commercial promise of the Internet. Speculators in the financial asset can profit, even when the project they have financed fails.
Economic bubbles have also been necessary. Occasionally, the object of speculation has been one of those fundamental technological innovations -- canals, railroads, electrification, automobiles, aviation, computers, the Internet -- that eventually transforms the economy. In these cases, the prospects of short-term financial gain from riding a bubble mobilizes far more investor capital than prudent professional investors would otherwise dole out. Moreover, the very momentum of the bubble forces those careful investors to join the herd lest their relative underperformance leave them with no funds to invest: Warren Buffet, who successfully steered clear of the great dotcom/telecom bubble of 1998–2000, is the exception that proves the rule.
Economic bubbles, as everyone knows, have also inevitably burst. And the consequences can be grave or transient. When the speculation infects the credit system that fuels the entire economy -- and especially when its object offers no prospect of increased economic productivity -- the consequences of its collapse are felt mostly in the short term and are unequivocally negative, maybe even catastrophic.
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