Thursday, October 4, 2007

Do bubbles slow economic growth?

"Will the presence of bubbles not slow economic growth in real economy? In China at the moment, investing in real assets may appear relatively unattractive compared with investing in equities, based on recent returns. Also, some SOE have been prosecuted for using funds earmarked for real investments to speculate in the markets instead. In the long run, is this bad for economic growth?"- Mattias

You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.

Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.

In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.

Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.

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