Bubble Ahoy!

Is the economy in for another bubble? We’ve seen the housing bubble pop, and before that we had a tech bubble. These events divide the profession, as every economist has their own pet theory describing bubbles. Economics news hunters seek these bubbles much like Ahab sought Moby Dick; the first to spot the bubble (or giant killer whale) is well rewarded.

Along these lines, the latest bubble rumor seems to be tech bubble 2.0. The evidence? Facebook just bought Instagram, that less-than-two-year-old picture website and app, for one billion dollars (as in $1,000,000,000). Writers with their eye on the prediction prize are going wild…what else could explain this phenomenon?

Well, basic economics. Not every change in money prices indicates a bubble. If Wal-Mart raises the price of laundry detergent overnight, I don’t run down the aisles telling people the laundry market is about to collapse, leaving us all dirty and stinky. Not only would this be obnoxious, it would be bad economics. Prices are the result of the valuations of people for goods relative to money. Or more simply, the laws of supply and demand. Facebook valued Instagram more than 1 billion dollars, and the owners on Instagram valued their company less than 1 billion.

So why does this purchase indicate a bubble? People are perplexed by the high price. I see two possible explanations behind the wonder. Either a) people are incredulous that Instagram just might be worth a billion dollars or b) Recent quantative easing has resulted in inflation, resulting in rising prices in the tech sector. That easing could also have resulted in artificially low interest rates, causing credit creation and intertemporal malinvestment.

The first option, sheer shock, does not (hopefully) merit news. In fact, we should want normal business fluctuations. If a company is valuable, it is because it is providing a desired service to consumers. By bidding up its net worth, the company is able to attract more resources to itself to continue providing its service. If the market did not operate this way, businesses who gave us stuff we really want would not receive funding for expansion.

The second option, general price inflation, should also not merit news. Since the Federal Reserve was established in 1913, the dollar has become progressively weaker. This sort of thing is nothing new. It would be one thing to say “Look how much prices have risen!” it is another to say “Look how much this price has risen!” while prices on average are generally climbing.

The second option’s cousin, credit expansion, is a similar story. With the recent rounds of quantitative easing, it is likely interest rates are artificially low. Again, we must wonder why tech companies? If credit expansion is occurring, why is it not affecting multiple, or potentially all, businesses? The case of the housing bubble there was an obvious culprit funneling cheap credit into the housing market: Fanny Mae and Freddy Mac. So if this is the next bubble, there would be a credible reason tech companies are getting an extra slice of the credit pie.

This sort of thinking should undergird every bubble theory. Bubbles are bad for economies, so they must be separated from regular business fluctuations. Suppose people got really into sofas, causing record sofa profits and investment. Suddenly, people lose interest, profits fall, and capital moves elsewhere. This would not be bad for the economy, which exists as we exchange to satisfy our ends. In fact, the reallocation of profits and capital would be a good thing, since we no longer want sofas.

How is Instagram any different? Sure there may be an element of inflation at play, and perhaps even some credit expansion in the works. We must also accept the fact that Facebook continues to grow, as does digital media and networking. This makes apps like Instagram, Tumblr, and Pinterest valuable. We must first eliminate the most obvious cause before we shout ‘Bubble Ahoy!’

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