Bubbles are Not Inflationary

Rumors are afoot of a web 2.0 bubble, which raises a sore point for me. People believe that bubbles are inflationary. From 1999 to 2000, the much-lauded Alan Greenspan raised interest rates six times in an effort to tame “irrational exuberance” and stave off inflation. The sixth interest rate hike sparked the crash of April, 2000, ending the longest peace time economic expansion in US history. Greenspan’s subsequent interest rate reversals then fueled the housing bubble, a fact which the now retired Greenspan has admitted.

The point I want to make here is, academically, a stock market bubble is not inflationary. This is a difficult point to articulate, so follow me like a leopard…

Let’s say I take my company public, selling 10 shares for $1 each. Zach (the public) buys all 10 shares for $1. Zach spent $10 and Jon got $10. Net change in dollars in the economy = zero.

Now let’s say there’s some “irrational exuberance.” Bob buys 1 share of Zach’s stock for $10. Now Zach has $10 and Jon has his $10. And Bob spent $10 and Zach spent $10. Net change = zero.

Let’s say Bob goes ape, and buys all remaining shares for $100 bucks a pop. Zach now has $910 and Jon has $10. Zach spent $10 and Bob spent $910. Net change = zero. The amount of real money in the economy doesn’t change! Just because there are millionaires-on-paper does not mean there is any change in real dollars in the economy.

Yes, there was irrationality when the stock market soared in the 90’s. But there was certainly some irrationality when it crashed, too. Greenspan got a lot of praise for being fortunate enough to preside over a technology boom and an economic expansion. But for a guy famous for the “soft landing” philosophy, he sure created a hard bump in 2000, precipitated the recessession of 2001-2002, and helped to create the housing bubble. Is that fair to say?

Maybe I’m being a bit harsh on Greenspan. I certainly couldn’t have done a better job! But I’ve always been intrigued at the disconnect between the media’s high opinion of Greenspan’s Fed performance, and opinions of those of us in the finance world.

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13 Responses to Bubbles are Not Inflationary

  1. Jim says:

    I’m not sure that I agree with what you wrote. Most money in the U.S. is in electronic form (i.e., not in physical dollar bills and coins) -I think it’s at least 75% of the money supply.

    When the stock market bubble was in full effect people were borrowing against their portfolio to purchase goods that they would not have been able to purchase if their portfolios were worth less. How is that not inflationary? Correct me if I am wrong about this, as I’m not an economics guru.

  2. Jon says:

    Jim,

    Great question! I do remember reading in business week about a dot com millionaire borrowing against his stock portfolio to purchase a $40 million home…

    So let’s say I buy a million dollar home, borrowed against my paper wealth. The bank pays the owner a million dollars, and I am now a million in debt. So net dollars in the economy has not changed.

    Now lets say Zach gives me ten million in cash to buy my home. I pay my bank debt and make nine million, and Zach is out ten million dollars. But again, the net dollars in the economy has not changed.

    If a large percentage of people began buying homes by borrowing against stock portfolios, I can see how that can become inflationary. The price of homes would be driven up, which drives up the price of goods and services, and eventually salaries, etc.

    But my impression is that this temporary phenomenon of buying homes against paper stock wealth was limited to a few dot com millionaires. And even in this scenario, the inflationary culprit is not the stock market. The culprit is the questionable practice of selling a mortgage based on paper stock wealth.

    Jon

  3. […] Imagine all the feuds in the finance blogosphere that would end instantly if Alan Greenspan put the smackdown in a comment post. I wonder what comments he would leave on this blog since I repeatedly blamed Greenspan for creating the real estate bubble. […]

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