by Marc Faber, originally posted at The Daily Reckoning,
I would like readers to consider carefully the fundamental difference between a “real economy” and a “financial economy.” In a real economy, the debt and equity markets as a percentage of GDP are small and are principally designed to channel savings into investments.
In a financial economy or “monetary-driven economy,” the capital market is far larger than GDP and channels savings not only into investments, but also continuously into colossal speculative bubbles. This isn’t to say that bubbles don’t occur in the real economy, but they are infrequent and are usually small compared with the size of the economy. So when these bubbles burst, they tend to inflict only limited damage on the economy.
In a financial economy, however, investment manias and stock market bubbles are so large that when they burst, considerable economic damage follows. I should like to stress that every investment bubble brings with it some major economic benefits, because a bubble leads either to a quantum jump in the rate of progress or to rising production capacities, which, once the bubble bursts, drive down prices and allow more consumers to benefit from the increased supplies.
In the 19th century, for example, the canal and railroad booms led to far lower transportation costs, from which the economy greatly benefited. The 1920s’ and 1990s’ innovation-driven booms led to significant capacity expansions and productivity improvements, which in the latter boom drove down the prices of new products such as PCs, cellular phones, servers and so on, and made them affordable to millions of additional consumers.
The energy boom of the late 1970s led to the application of new oil extracting and drilling technologies and to more efficient methods of energy usage, as well as to energy conservation, which, after 1980, drove down the price of oil in real terms to around the level of the early 1970s. Even the silly real estate bubbles we experienced in Asia in the 1990s had their benefits. Huge overbuilding led to a collapse in real estate prices, which, after 1998, led to very affordable residential and commercial property prices.
So my view is that capital spending booms, which inevitably lead to minor or major investment manias, are a necessary and integral part of the capitalistic system. They drive progress and development, lower production costs and increase productivity, even if there is inevitably some pain in the bust that follows every boom.
The point is, however, that in the real economy (a small capital market), bubbles tend to be contained by the availability of savings and credit, whereas in the financial economy (a disproportionately large capital market compared with the economy), the unlimited availability of credit leads to speculative bubbles, which get totally out of hand.
In other words, whereas every bubble will create some “white elephant” investments (investments that don’t make any economic sense under any circumstances), in financial economies’ bubbles, the quantity and aggregate size of “white elephant” investments is of such a colossal magnitude that the economic benefits that arise from every investment boom, which I alluded to above, can be more than offset by the money and wealth destruction that arises during the bust. This is so because in a financial economy, far too much speculative and leveraged capital becomes immobilized in totally unproductive “white elephant” investments.