There are three kinds of “bubbles” -  a term often used loosely when asset prices rise a great deal and then fall sharply, without an obvious corresponding shift in “fundamentals“.

1. A short-run bubble.  Think about 17th century Dutch Tulip Mania: spectacular, probably disruptive, but not a major reason for the decline of the Netherlands as a global power.
2. A distorting bubble.  In this case, the increase in asset prices contributes to a reallocation of resources across sectors.  Think of the Dot-com Bubble: fortunes were made and lost, the collapse was scary to many, and – at the end of the day – you’ve built the Internet and some good companies.
3. A political bubble.  Here rising asset prices generate resources that can be fed into the political process, through bribes, building politicians’ careers, and lobbying of all kinds.  Bubbles in Emerging Markets often generate resources that impact the political process, sometimes in good ways – but most often in bad ways, which eventually contribute to a collapse.

Larry Summers seems to think we are dealing with the consequences of bubble type #1.  In his speech last week, “the bubble” is a modern deus ex machina – it explains why we have a crisis, but there is no explanation of where this bubble came from, what exactly was bubbling, and what changes this bubble brought to the real economy or to our politics.

To the extent that Summers talks about the bubble at all, it seems to be in residential real estate.  It’s hard to argue that there was an unsustainable run-up in housing prices and that the fall has real consequences.  But what model – or even story – can explain the size of the global disruption we are facing without reference to what happened specifically in the financial sector?

The overall official consensus - which Summers continues to shape – seems to be that our problems are: housing bubble plus bad management in a few big financial firms and slightly too weak regulation.  So we’ll tweak regulation, ever so gently, and let the “good” big firms gobble up the people, market share, and perhaps even assets of those that fall by the wayside.

But what if we are looking at the effects of a distorting bubble?  In previous formulations – but not last week – Summers acknowledged that when financial sector profits hit 40 percent of total corporate profits, a few years ago, we should have seen that as a “warning sign”.  But was this a warning sign of something just about houses, or more broadly about the financial process in and around securitization that was both feeding the housing price increase and also reflecting a longer-run shift of resources into the financial sector?

Even James Surowiecki, a most articulate defender of our current financial sector, implicitly concedes that as a percent of GDP, finance is likely to fall from around 8 percent to GDP back towards 6 percent of GDP (its level of the mid-1990s; see slide 19 in my recent presentation; update, this link now fixed).  Of course, there is no way to know exactly where finance is heading – except that it is likely down as a share of the economy.

If the bubble (or metaboom with a series of bubbles) was in finance and pulled resources into that sector, we face an adjustment away from Peak Finance – and perhaps this will even more overshadow the next decade than Peak Oil.

The economic adjustment will not be easy for the U.S. but it will be much more painful for smaller countries that have specialized in finance.  The U.S., however, will likely struggle with the political adjustment – the financiers will not easily give up their licence to extract resources from citizens, either directly or through newly found rents channeled through the state (and coming ultimately out of your pocket, of course).

The political consequences of Peak Finance greatly complicate our economic recovery.

By Simon Johnson