SPECULATIVE GROWTH : HINTS FROM THE US ECONOMY Ricardo

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. •Respectively: MIT and NBER; MIT; DELTA and CEPR (DELTA is a joint CNRS-EHESS-ENS reseajch unit). E-mail: [email protected]; [email protected]; [email protected]. We are grateful to Bjorn Briigemann for outstanding research assistance and to the European Central Bank Research Department and the International Institute for Economic Studies for their hospitality. We thank Franklin Allen, Marios Angeletos, Gadi Barlevy, Olivier Blanchard, Thomas Chaney, Peter Diamond, Thomas Philippon, Frank Portier, Pietro Reichlin, Jean Tirole, Jaume Ventura and seminar participants at Boston University, CORE, DELTA, ESSIM, Harvard, IIES, MIT, the NBER EFG meetings. Northwestern, Toulouse, and Wharton for useful comments. Caballero thanks the NSF for financial support. This is an extensively revised and transformed version of NBER WP #9831, December 2002.