News media circulates with warnings about speculative bubbles in artificial intelligence and cryptocurrency, but history shows that not all bubbles are bad for the economy, and some may even aid long-term growth. In new research, Jared Bernstein, Aneil Kovvali and Jeffery Y. Zhang distinguish between constructive and destructive bubbles and suggest how government and financial institutions can limit the consequences of the latter.
Speculative bubbles get a bad rap, and often deservedly so. They are often the product of irrational exuberance, herd behavior, mania, or a failure to learn from the mistakes of the past. Their consequences can generate lasting economic damage and political instability. Scholars connect a direct line from banks’ splurges on subprime mortgages in the aughts that led to the 2007-08 Global Financial Crisis to today’s populist movements in the United States. The very name “bubble” suggests something flimsy and ephemeral that leaves behind nothing but air after it pops.
There is much truth to this story, but it obscures other complex dynamics. Many bubbles begin with promising developments in the real economy that suggest a new and valuable condition is at hand. In a sense, bubbles are to be expected when a promising new technology arrives. Organic enthusiasm is amplified in financial markets as investors seek opportunities to participate in expected gains. As a bubble inflates, and the most stable businesses become expensive, investors either pump those businesses beyond their fair value or chase increasingly speculative projects. Private returns to investors become less likely to justify the risks involved. Investors, along with innocent bystanders, suffer grievous losses when the bubble pops.
However, many of the projects financed by the bubble continue to operate and generate value for new owners. Such was the case with bubbles in railroads in the 19th century, electrification in the early 20th century, and instantaneous communication and computation at the turn of the 21st century. These technologies continued (and continue) to provide value to the economy and spurred innovation and growth in other industries. Bubbles may be capitalism’s way of shaking up an existing equilibrium and building infrastructure or financing innovation at a level beyond what the existing equilibrium can support. Bubbles that support the development of infrastructure or productivity enhancing technologies can be called “constructive bubbles.”
Of course, many bubbles do not support infrastructure or technological innovation but are driven primarily, or even exclusively, by financial market developments. Financial innovation may drive euphoric new prices in financial markets without a genuine connection to real world improvements in productivity or human welfare. For example, financial market innovations in securitization drove the housing market bubble of the aughts. Bubbles driven by financial markets can be more dangerous than constructive bubbles, as their collapses can cause harm that is not limited to specific sectors of the economy due to the nodal role banks and other financial institutions play. And they often create no new infrastructure or ideas with which to recoup value from the devastation.
What kinds of bubbles are AI and crypto?
Today, our economy is experiencing two bubbles in artificial intelligence and cryptocurrency.
According to our taxonomy, enthusiasm for AI may have characteristics of a constructive bubble. While AI firms may at some point generate the private profits and thereby the returns on investment necessary to match investors’ expectations, that is unlikely to be the case now. Meanwhile, the sector is absorbing historically large amounts of investment capital. Should investors grow impatient and begin to withdraw from the sector, this potential bubble will burst. Whether that occurs or not, however, the technology may have strong productivity-enhancing potential for the long term.
By contrast, enthusiasm for cryptocurrencies has the characteristics of a destructive bubble. The core change is an innovation in finance, not a productivity-enhancing advance. While some financial innovations can benefit consumers—say, through more efficient payment systems—cryptocurrencies fail as a reliable store of value, are not widely accepted (have few practical use cases), lack transparency, and are therefore widely used for illicit purposes, making it a potentially highly destructive bubble.
How regulators should address bubbles
A nuanced understanding of bubbles complicates basic understandings about fields like securities law and financial regulation. While legal scholars and policymakers ordinarily assume that it is desirable to pursue fundamental efficiency—where the prices of financial assets closely reflect rational expectations about the value of the cashflows they generate and where bubbles are impossible—a measure of irrationality may, in some instances, actually produce social benefits.
It is important that the law address these nuances to protect citizens and the economy from destructive bubbles while reaping the fruit of constructive ones. Traditional macroeconomic tools like changing interest rates are blunt instruments that act on the economy as a whole and cannot distinguish between potentially productive and destructive bubbles. Intervention must be more precise.
Legal rules permit or restrain bubbles and facilitate or encumber the process of rationalization and recovery that follows. Legal tools also offer policymakers and regulators the ability to draw fine distinctions and act surgically to support useful investment while deterring wasteful behavior.
First, legal reforms should channel early speculation into promising opportunities. At the same time, the law should seek to avoid the wrong type of bubbles. Financial regulation could, for example, seek to make financial institutions and systems boring, so that they serve as facilitators of bubbles driven by real economy developments as opposed to independent drivers of new bubbles. Policymakers might adopt prescriptive limits on financial products, like binding limits on debt-to-income ratios on mortgages or prohibitions on cryptocurrencies, or take steps to expand the regulatory perimeter to cover a broader range of money-like securities.
Ideally, these mechanisms should operate automatically to channel market enthusiasm into genuinely productive projects, instead of requiring officials to successfully distinguish between good and bad bubbles. Public policy can also enhance the capacity of private markets to make the necessary distinctions. Indeed, one benefit of competitive markets is that they enhance the economy’s capacity to identify value-creating products and cost-efficient production processes. Robust antitrust policy can support this kind of competition.
Second, legal reforms should manage the inflation of bubbles and their impacts on the real economy. Enhanced disclosure may help reveal that promising strategies have not paid off. The law should also work to limit the impact of bubbles on real investment by critical industries and on ordinary investors. As an illustration, the race to build AI data centers could distort investment by electric utilities absent careful guardrails. And plans to introduce risky new asset classes into retirement accounts could spread the pain of an ending bubble to ordinary people.
Third, legal reforms should manage the process of rationalization following a bubble. Financial market reforms could help ensure that the sudden popping of a bubble does not lead to immediate impacts on the real economy, giving business leaders and policymakers time to pivot and save the valuable products of a bubble. A countercyclical capital buffer requirement at financial institutions would ensure that they had capital ready to deploy during a crisis. The government can also help rationalize industries following a bubble by financing, restructuring, or transitioning companies to a regulated industry structure.
As market enthusiasm carries AI stock and cryptocurrency prices to eye-watering highs, a nuanced analysis is urgently necessary. Speculation does have its uses, and it would be a mistake to stamp out private enthusiasm in favor of government priorities. But not all bubbles are constructive. Policymakers must be ready to protect workers, consumers, small investors, and taxpayers from bubbles and their aftermath.
Authors’ Disclosures: The authors report no conflicts of interest. You can read our disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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