Speculative growth

Description

We propose a framework for understanding recurrent historical episodes of vigorous economic expansion accompanied by extreme asset valuations, as exhibited by the U.S. in the 1990s. We interpret this phenomenon as a high-valuation equilibrium with a low effective cost of capital based on optimism about the future availability of funds for investment. The key to the sustainability of such an equilibrium is feedback from increased growth to an increase in the supply of effective funding. We show that such feedback arises naturally when an expansion comes with technological progress in the capital producing sector, when fiscal rules generate sustained fiscal surpluses, when the rest of the world has lower expansion potential, and when financial constraints are relaxed by the expansion itself. Arguably, these ingredients were all simultaneously present in the U.S. during the 1990s. We also show that such expansions can be welfare improving but they can crash. The latter is more likely if bubbles develop along the expansionary path. These (rational) bubbles can emerge even when the interest rate exceeds the rate of growth of the economy. Keywords: Bubbles, investment, cost of capital, growth-saving feedback, multiple equilibria, dynamic efficiency and inefficiency, new economy, spillovers, fiscal and current account surpluses. JEL Classifications: D0, D9, E2, E3, G1, H3.

Subjects

Series Statement

• Working paper series / Massachusetts Institute of Technology, Dept. of Economics -- working paper 02-45
• Working paper (Massachusetts Institute of Technology. Dept. of Economics) -- no. 02-45.

Links

• http://ssrn.com/abstract=355901