The Next Bubble

Eric Janszen's article, The Next Bubble, provides a short history of our now bipolar economy. It all starts with an invention or innovation that creates a new and unfamiliar space for investment. People with credibility move in, less savvy investors follow, not wanting to be left behind. The amounts of money that move around create a haze where certain assets become way overvalued. Eventually everybody comes to their senses, often all at once, like crashing into a brick wall. Investors rush to take their money out as quickly as they originally put it in. Janszen was a honcho at a VC firm during the 90s so he has first-hand experience with the pattern.

While such frenzies have a long history (the article mentions the South Sea Bubble of 1720), their frequency is increasing. Whereas previously the boom-bust cycle occurred on the scale of decades, after the dot-com crash of 2000, the so-called subprime bubble began foaming in 2003.

When the dot-com bubble crashed, about $7 trillion in fictitious value needed to be dissipated in a way that wouldn't create shocks throughout the US (and world) economy. The bubble resulted in a glut of workers without jobs and companies without customers, and on the other side reactionary, overly-cautious investors who no longer wanted to risk their money. Since the 1929 crash, the strategy the US has taken to recover is called Keynesian reflation: cut taxes, increase federal spending, depreciate the dollar, and lower interest rates. These moves are intended to counter the reaction to the crash (ie: keep investors from hoarding their money in savings accounts) and keep money moving so that the economy can resettle smoothly.

Reflation worked pretty well in the early 2000s because the federal government was running a surplus in the 90s, the dollar was high, taxes had room to decrease, and the fed funds rate was 6%. However, it's going to be a lot harder to contain the reaction to this most recent bubble, which is estimated at around $12 trillion in fictitious value. The government has been running a deficit, the dollar is low, and tax cuts from the early 2000s are still in effect. The fed funds rate went from 6.5% in 2000 down to 1% in 2003 to counter the dot-com crash. It recovered up to 5.25% in summer of 2006, but is now at 3%, and may go down another 1% within a week. There is worry that it won't be able to fall low enough to counter the crash.

For the US economy to survive, Janszen predicts that another bubble will need to form. That is, a new frontier will need to open up and provide opportunity for investors, create jobs, etc. I won't give it away, but you can probably guess what it is (hint: it's what the world needs). Or you can read the article, which I recommend.