The Next Bubble

We've heard the warnings before. Alternative energy, so the analysts say, is productive of the same irrational exuberance that begot the dot.com and telecom bubbles of a decade ago. In fact, we've previously devoted editorial space to the topic, but the discussion has suddenly grown much more animated as the result of an article in the current issue of Harpers that is already generating a great deal of buzz—hence our revisiting this area.

The article is entitled "The Next Bubble – Priming the markets for tomorrow's big crash" and the author is Eric Janszen a venture capitalist who edits an online financial journal entitled www.itulip.com which is devoted to the subject of booms and bubbles.

Janszen is not the usual New Economy blowhard of the Esther Dyson, George Gilder stripe. Where the latter were the cheerleaders feeding the tumult, he's cool, rational, and analytical and he has a lot to say of general interest. In short, he's not some stock tout trying to pick your pocket.

So what does he say that's so interesting? Janszen notes very correctly that financial bubbles appear to be coming thick and fast in the present era. He observes, somewhat less correctly, that in the past the bursting of a big bubble would be followed by years of soul searching on the part of investors, and that as a consequence really large and expansive bubbles were signal rarities. But this is not the case at present, Janszen contends. A big bust is immediately followed by another big boom and hyper-valuation of assets. Nobody seems to remember getting burned in the preceding market frenzy.

Janszen further states that the U.S. economic system is now dependent on bubbles to maintain momentum, hence their increasing frequency. Politicians, financial institutions, manufacturers, and service organizations all conspire to foster bubbles—the politicians providing enabling legislation and financial incentives, and the investment community funding, while the individual companies and the consumers simply participate.

In the process assets get bid up and wildly overvalued, and the time comes when the price can be bid up no higher. At that point investors begin a classic panic sell off because everyone simultaneously wants to realize the maximum value of the now manifestly overvalued asset.

Janszen focuses on two specific recent bubbles, the dot.com episode and the still deflating housing bubble. He explains very well the mechanics of the housing bubble and somewhat less well the dynamics of the dot.com phenomenon and then goes on to suggest that alternative energy will be the locus of the next bubble. I'll explain is reasoning in regard to an alternative energy bubble in a later section.

Janszen does not entirely explain why the American economy should require such violent stimuli today when it certainly did not in the past. Remember that from 1945 until the nineteen seventies the American economy was incomparably robust and at the same time remarkably well damped, with long term steady industrial growth, a subdued stock market, a stable currency, and nearly full employment. The oscillations of the business cycle were not such as to disturb the everyday lives of the citizenry, and such downturns as occurred were infrequent and relatively benign—more in the nature of regroupings or corrections than the violent crashes of the nineteenth and early twentieth centuries.

A rollercoaster economy returned in the nineteen seventies, however, and has been with us ever since, and Janszen's assertion that it is now necessary demands analysis because, while counterintuitive, it may just be right.

The dot.com Singularity

In the summer of 2002 I wrote a series of articles on technology booms of the past for my employer at that time, "America's Network", the number two telecom business journal and a major beneficiary of the telecom investment boom that closely followed the dot.com explosion. By that time, as you may remember, the larger tech boom of the nineties was clearly over and Silicon Valley had become the new rust belt.

I studied the history of technology booms very extensively prior to composing the articles, and I discovered to my amazement that financial bubbles associated with new technologies were quite rare, the railroad building manias of the nineteenth century providing the only close analogy. Oh, there was investment aplenty in new technology throughout the nineteenth and twentieth centuries but the kind of overvaluation that occurred with Internet and telecom stocks a decade ago was almost without precedent. Nineteenth century railroad stocks, for instance, only appreciated to a similar degree but once, that instance occurring in England of the eighteen forties, as chronicled in Anthony Trollope's "The Way We Live Now" the best fictional treatment ever written of high finance and shady business dealings.

True, automobile manufacturer stocks were over-valued in the twenties, but then so were most blue chips, while the new technology of broadcast radio, the real tech boom of the twenties, did not exhibit the same kind of crazy investment patterns characteristic of dot.com and telecom companies.

After some initial turbulence most of the technological revolutions of nineteenth and twentieth centuries such as Bessemer steel production, electrification, telephony, automotive transport, airlines, the rise of the modern paper industry, business machines, and consumer electronics, to name just a few, manifested good, steady, long term growth and profitability. In many cases there were way too many companies entering the market and ensuing mass bankruptcies as noncompetitive firms folded, but the investment losses tended to be confined to handfuls of angel investors. The major investment banks, which began to assume importance in the growth of new industries in the 1880s, generally bet correctly on the companies in emerging industrial sectors and generally profited from the steady growth of industry in the United States.

So was the dot.com investment bubble a singularity, or is it one with the housing bubble as Janszen suggests? And what has it to do ultimately with alternative energy?

Bubble 2.0

The housing bubble is in many ways far more comprehensible than the tech bubble because it has so many antecedents, albeit all of those have been on the local rather than the national level.

Most bubbles of the past have involved either real estate of one sort or another or the extractive industries such as mining and petroleum. And, more often than not, real estate booms involve commercial or industrial real estate. Enormous escalations in the price of residential real estate are much rarer though not without precedent.

Probably the greatest previous residential real estate boom in the history of the United States occurred in Florida in the early and mid nineteen twenties, ending in early 1926 when a perfect storm literally hit south Florida—a hurricane that flattened much of Miami and a coincidental collapse in real estate prices which occurred immediately prior.

The Florida real estate extravaganza was a financial frenzy characterized by massive overvaluation of properties, a tremendous construction boom, a plethora of young, aggressive twenty something traders known as "binder boys" with a few "binder girls" thrown in, nationwide advertising in the mass media, and finally by the emergence of unique financial instruments for trading properties including very complex derivatives known as "binders", pronounced with a short i.

It wasn't all smoke and mirrors. Southern Florida really was being settled rapidly after being nearly uninhabited for decades, and it was already economically important as the major terminal for the importation of bootleg booze into the United States, but the boom itself was seen by most of the participants as a gamble and a gold rush. All of the insiders knew there was a lot of flim flam going on. At any rate, few of the binder boys regretted their fling and some made quite a lot of money in commissions. The last speculators entering the market naturally suffered, but the subsequent crash had almost no effect on the economy as a whole which kept on roaring until the end of 1929 when it all came down so suddenly. As is the case during past ten years, America in the twenties endured two crashes, the 1926 Florida real estate crash and the stock market crash of 1929, but the first only impacted the state of Florida while the second arguably brought down the whole economy.

The sunbelt boom in office real estate in the late eighties funded by the then newly deregulated Savings & Loan industry was something else entirely, a real estate bust with real reverberations. Many people were badly hurt, especially the elderly who had put their savings in the supposedly safe S&Ps, and entire municipal economies were depressed where the crash was most severe.

Even more catastrophic was the so-called "Asian Flu" of 1997 which combined a real estate boom in office space with a tech boom associated with the rapid industrialization of China and Southeast Asia. It devastated whole regional economies and is arguably the only real estate boom gone bust on a par with the current housing bubble in the U.S., though of course it primarily involved commercial properties rather than residences.

So, if there have been relatively few full blown tech bubbles, there have been quite a number of real estate bubbles both here and abroad. Nevertheless, if we examine past booms closely we find that our current housing bubble like the recent tech bubble is fairly unique—something new under the sun.

Most real estate booms of the past beginning with the Bank of Scotland and South Sea Bubble affairs of the early eighteenth century were connected with growth, settlement, and migration—in other words, the really big booms don't involve trades of existing property.

A town springs up where the railroad or the interstate is slated to go. A city arises adjacent to a new port facility. A block of condominiums and a shopping mall appear next to a new exurban industrial park. Or, to cite a specific historical example, the city of San Francisco quadrupled its population to serve the California gold fields in 1850, and then, less than a decade later, grew exponentially once again to become the financial center for the Comstock lode in the Nevada silver country. San Francisco was a boomtown, but it was boomtown with real economic activity behind it.

Thus in most land booms there have been good reasons for the boom towns to appear in the first place. They served booming enterprises in their vicinity, that is, the real estate boom ultimately supported an industrial boom, although sometimes the connection was indirect. For instance, Chicago built the first street car suburbs in the U.S. which resulted in escalating prices for rural property around the city. Those suburbs housed individuals who were employed in the booming factories and mercantile operations located at the city's core—in other words, they were the products of rapid industrialization and simultaneously the stimulus to further industrialization in the sense that they provided virtually unlimited housing for urban workers along with new patterns of consumption.

More apropos to the subject of alternative fuels, the city of Rifle, Colorado became a boomtown when Exxon began the construction of a 100,000 barrel per day oil shale operation at the nearby Colony Project. When Exxon abandoned the project in May of 1982 real estate prices almost immediately collapsed.

Now if we look at the housing bubble of the present we see something rather different and disturbingly so. Here the boom primarily involves existing properties rather than new construction and was fueled by easy credit and variable rate mortgages involving poor credit risks and known for that reason as subprime loans. Suddenly hordes of less than credit worthy individuals were in the housing market as well as people of means who were simply overextended.

What is interesting about this boom that appears to be a bubble is the way that it served both the financial industry and the homeowner as well as the speculator.

Local banks could sell the subprime mortgages to large investment banks where they would be packaged as mortgage funds which could then be resold and repackaged with yet larger aggregations of debt, presumably spreading the risk, and, ironically, concealing liabilities, while at the same time allowing institutional investors all over the world to participate in this huge financial market. In many respects these instruments are equivalent to the corporate junk bonds popularized by Michael Milken at Drexel Burnham Lambert although unlike the latter they are ensured. The problem is that the insurers appear unable to cover the losses. In this respect the unfolding debacle more closely resembles the savings and loan debacle although there insurance was provided by the government and taxpayers ultimately absorbed the loss.

As in any rising market the boom market for real estate, the nationwide housing bubble provided home owners with an appreciating asset against which to borrow, enabling them to refinance on what appeared to be more and more favorable terms. Low prime interest rates were provided by the Federal Reserve to facilitate such transactions and to foster a runaway housing market. Just as many middle class individuals, including the author, utilized stock and mutual fund appreciations during nineties to engage in lavish spending on consumer goods and services, these same individuals, again including the author, derived similar infusions of spending money from the rising price of their homes and access to new loans it afforded them. But whereas in the first instance the spending money was generally obtained by the liquidation of the investment funds and did not further expose the beneficiary, in the second instance the spending was financed by additional debt, a very dangerous state of affairs.

Anyone who has studied the development of modern consumer culture, particularly in the United States, realizes that mass affluence in terms of an elevated life style, can only be had by a decrease in personal savings and a growth in personal debt. Real estate developers building the first street car suburbs simultaneously created the first subprime mortgages in the 1890s, and Henry Ford and Alfred P. Sloan of General Motors soon realized that mass sales of automobiles could only take place if the cars were financed and the customers indebted. Later retailers adopted the installment purchase plan and financed consumption of smaller durable goods by their customers. Later still, federally ensured home loans came into being, stimulating a vast growth in home ownership along an advancing internal frontier known as suburbia.

Although wages rose fairly rapidly over the first seven decades of the twentieth century, if we exclude the decade of the thirties, there was always resistance on the part of corporate America to raising wages and lowering prices and thus there was always a problem in funding consumption. In other nations, such as post World War II Japan, corporations chose not to develop local markets and concentrated on exports. Japanese consumers simply could not buy on credit until the 1970s which sharply limited internal consumption. But the dependence of American firms on the home market forestalled any such a strategy here. Consumers simply had to consume or the manufacturing and service sectors would collapse.

Nevertheless, consumer debt was fairly well controlled during the period between 1948 and 1966 when America was experiencing rapid growth in both gross domestic product and personal wages. The prices of consumer goods were declining even while wages were increasing and so few but the improvident felt pinched or need to borrow large sums. Moreover, installment purchases had to be individually negotiating, militating against excessive debt financed impulse purchases, and home mortgages were generally fixed and long term and very seldom renegotiated or refinanced. The change came in the seventies when credit card issuance proliferated while at the same time a multitude of new consumer products began to appear including microwave ovens, videocassette recorders, personal computers, and somewhat later big screen television, compact disc players, and mobile telephones. At the same time, the refinancing of home mortgages began to grow in popularity, particularly here in Southern California where a rapid appreciation in housing prices was occurring.

From 1972 until the middle 90s real wages stagnated for all but the wealthiest Americans, and yet consumption grew at a remarkable pace. And much of what was consumed came from abroad. At the same time government debt and the purchase of government bonds by foreign investors grew apace. The huge growth of military spending under the Reagan administration exerted a Keynesian effect upon the economy which was amplified by an overheated stock market, the junk bond phenomenon, and the deregulation of the savings and loan industry.

The preconditions for a very serious correction, even a market collapse, were in place by the late eighties, and a global financial disaster was narrowly averted during the stock market crash of 1987. But averted it was. A recession followed only at after a considerable interval, and in fact the foundations of an economic revival had already been laid before the crash occurred.

Two factors appear to have been paramount in mitigating the effects of the crash and ultimately bringing about the long boom of the nineties. The first was the severe devaluation of the currency in 1986 which made a number of American industries competitive in world markets again. The second was the dominance of the U.S. in the new technologies of personal computing, computer networking, computer software, and fiber optic communications.

The assets of the companies participating in the electronic communications boom of the nineties were certainly wildly overvalued, but the transformation in American economic life was real. Wealth was created, and much of the consumer spending of the period was predicated upon rising real wages and on return on investment, not on the accumulation of personal debt.

But as we know, the economy eventually turned very sour, and the overvaluation of assets during the roaring nineties surely played a major role in precipitating the downturn.

The current decade got off to a shaky economic start, and the bursting of the tech bubble exactly coincided with the change in Administrations. This was followed by a recession, as Janszen notes, but one of limited severity except for those, employed as the author was, within the collapsing tech sector.

The Bush Administration obviously drew strong support, at least initially, from its vigorous if misguided response to the disasters of 9/11, but Administration officials wanted a thriving economy as well. But since the tech sector was no longer the engine driving the economy and traditional industries like the manufacturing of durable goods continued their long term decline, no ready means of re-inflating the economy appeared to be at hand. And indeed, new construction, the foundation of most past real estate booms, was fairly stagnant as well.

To what extent the Bush stimulus package was cogently planned will be long be debated. The unprecedented participation of East Asia in the Federal bond market could scarcely have been predicted and that provided a potent stimulus to the economy because it allowed the government to expand and to pump cash into the economy, so to some extent the mini-boom of the last four years was serendipitous. As in the case of the Reagan era military buildup, Bush's own even more enormous military expansion exerted an effect that was essentially Keynesian, but whether Bush or his colleagues appreciated that this would be the case is uncertain. At any rate, since that expansion created no real wealth and was financed with debt that had to be repaid, it provided a shaky foundation for the boom that followed.

Of course the elevation of residential real estate prices, which followed from a heightened demand for home ownership in the face of a flat construction industry, provided an even more precarious foundation because it was financed entirely with personal debt and individual debtors cannot raise taxes to service their debts. A crash was inevitable and with it a surge in personal bankruptcies.

George W. Bush, who tied his political fortunes to cutting taxes, could of course have raised taxes to service the national debt and repay bond holders, and to that extent rein in the economy and stabilize the dollar, but he was adamantly and irrevocably opposed to doing so. His solution was that of profligate national leaders from time immemorial, depreciate the currency and pay the debts in devalued dollars. Which inevitably leads to inflation and a decline in real earning power, and thus imposes a severe though indirect levy on those who believed that they were receiving nothing but tax cuts from the Federal government.

How Bush's successor will deal with the effects of his various expedients remains to be seen. Nor can we predict the severity of the economic shocks that will surely follow. But we can rest assured that a rapid resumption of good times will not occur, unless, of course another bubble can be launched and maybe not even then.

What's to Come

Neither individuals nor the Federal Government are in a position to accumulate any more debt by any obvious means. We have read that the Government of Iraq, which is entirely beholden to the current Administration, has been spending most of its oil revenues for the purchase of Federal bonds rather than the reconstruction of that ravaged country. One may speculate that Prime Minister Nouri al-Maliki is under heavy pressure to do so, and that it represents a desperate attempt to shore up bond prices and at least service current debt if not increase it. In essence then Iraq is being taxed to pay for its own destruction in a perverse distortion of traditional war reparations.

One could conceive of President McCain following a similar course in Iran which is similarly well endowed with oil, and perhaps he might have to. Because if the United States were to invade that place, the Chinese, who obtain much of their petroleum from Iran, would surely cease to buy bonds and might even begin selling off their holdings in an attempt to crash the U.S. bond market. But whether there is anything McCain can do to blow up another major bubble may be doubted. At best he can generate a froth of little bubbles.

So what about Janszen's notion that U.S. industry alone can blow a bubble out of alternative energy?

Investment in that sector is certainly increasing, and a favorable legislative and regulatory climate is likely to emerge. The problem we see lies in the very different nature of the energy business vis a vis computing and telecommunications.

Here's the problem. Replacing the electrical grid with clean power sources or the transportation system with zero emission vehicles are monumental undertaking. It's not like funding some code monkeys in a garage to cook up a social networking platform. And the other problem is low rate of return and the long returns on investment associated with electrical utilities. True, one could choose to invest only in enabling technologies, intellectual property, as it were, but so far in the field of alternative energy those types of investments have not performed on a par with the nineties tech superstars.

The initial electrical and motorized transportation systems got built because the U.S. Money Trust commanded by the House of Morgan got behind them and directed a considerable portion of total investment dollars into them. A few financial titans essentially made it all come together, people, who, it as it happened, were patient investors and genuinely concerned about the overall industrial development of the nation. A similar situation does not obtain today.

It must be observed, however, that America's electrical utilities did experience a single episode of boom and bust, and episode that is nearly forgotten today but which coincided with the stock market crash of 1929 and arguably contributed greatly to the financial panic that ultimately begot the Great Depression.

The growth of the great American electrical transmission system owes much to one Samuel Insull, an erstwhile employee of Thomas Edison, who built not one but two electrical grids, the nearly nationwide and deeply flawed DC transmission system that Edison Electric supported, and then the modern high voltage AC system that Westinghouse developed and Edison Corporation eventually adopted after Edison himself had been ousted by his board.

Insull slashed prices for electrical power, encouraged the development of home electrical appliances, and strongly promoted the use of electricity in the home. During the first three decades of the twentieth century the electrical generation industry exploded across America under Insull's guidance. But Insull was more than just a promoter, he was also a financier and a deeply creative one.

Electrical generator plants and power lines were expensive to build and froze up investor capital for long periods of time, making them relatively unattractive investments for individuals. To make the capital available to local operators, Insull put together vast investment pools and established enormous interlocking holding companies that held huge amounts of equity in local electrical systems. Insull created a virtual monopoly that yet appeared to be a congery of independents. The whole vast scheme was highly leveraged and vastly overvalued and depended upon continual growth and expansion to pay off investors. It was half Ponzi scheme, half real growth industry, but when the growth halted at the end of the nineteen twenties, near financial collapse followed. Further expansion of the electrical system only took place after massive Federal stimulus in the form of Roosevelt's Rural Electrification program.

Could a similar financial bubble undergird a transition to alternative energy? It's not inconceivable though the type of holding company structure favored by Insull is very old fashioned and is unlikely to be revived in this century. My guess an alternative bubble would like entirely different and would probably involve financial instruments not in common use today. Of course, Janszen believes that bubble is imminent and so they must already be present if he's right.
But I'm not sure he is.