When Speculation Builds: Why Some Bubbles Can Fuel Long-Term Growth

News coverage often warns of speculative bubbles in artificial intelligence and cryptocurrency, but history suggests that not every bubble is harmful. Some can help finance transformative technologies and support long-term economic growth. In new research, Jared Bernstein, Aneil Kovvali and Jeffery Y. Zhang separate constructive bubbles from destructive ones and consider how governments and financial regulators can reduce the damage caused by the latter.

Speculative bubbles are widely criticized, and often with good reason. They are frequently fueled by irrational optimism, herd behavior, market mania or a failure to apply lessons from earlier crises. When they burst, they can leave behind severe economic damage and political instability. Scholars have traced a line from banks’ aggressive exposure to subprime mortgages in the 2000s and the 2007-08 global financial crisis to the rise of populist movements in the United States. The term “bubble” itself implies something fragile and temporary, leaving little behind once it collapses.

That account captures an important truth, but it misses a more complicated reality. Many bubbles begin with genuine advances in the real economy that point to a valuable new opportunity. When a promising technology emerges, excitement can build quickly. Financial markets amplify that enthusiasm as investors compete to share in expected gains. As valuations rise and established companies become expensive, investors may push prices beyond reasonable levels or turn to increasingly speculative ventures. At that stage, private returns may no longer justify the risks, and both investors and uninvolved bystanders can suffer major losses when the bubble bursts.

Yet many projects financed during a bubble survive the crash and continue creating value under new ownership. This pattern appeared in the railroad boom of the 19th century, the electrification wave of the early 20th century, and the rise of instant communication and computing around the turn of the 21st century. These technologies continued to benefit the economy and encouraged innovation across other industries. In some cases, bubbles may disrupt an existing economic equilibrium and help build infrastructure or finance innovation beyond what more stable markets would support. Bubbles that contribute to infrastructure or productivity-enhancing technologies can be understood as “constructive bubbles.”

Not all bubbles, however, support infrastructure or technological progress. Some are driven primarily, or entirely, by developments within financial markets. Financial innovation can produce surging asset prices without a meaningful connection to gains in productivity or human welfare. The housing bubble of the 2000s, for example, was heavily shaped by innovations in securitization. Bubbles rooted in finance can be especially dangerous because their collapse may spread far beyond a single sector, particularly when banks and other financial institutions are central to the system. They also often leave behind fewer productive assets to offset the damage.

Are AI and cryptocurrency constructive or destructive?

The current economy features two prominent speculative episodes: artificial intelligence and cryptocurrency.

Under this framework, enthusiasm for AI may have some features of a constructive bubble. AI companies may eventually generate enough private profit to justify investor expectations, but that outcome is far from assured today. The sector is already absorbing historically large volumes of investment capital. If investors lose patience and pull back, the boom could burst. Even so, the underlying technology may have significant long-term potential to raise productivity.

Cryptocurrency enthusiasm, by contrast, more closely resembles a destructive bubble. Its central innovation is financial rather than productivity-enhancing. While some financial innovations can benefit consumers, such as faster or cheaper payment systems, cryptocurrencies have struggled to function as reliable stores of value, remain limited in widespread acceptance and practical use, and often lack transparency. Their association with illicit activity also raises serious concerns, making the sector potentially far more damaging if the bubble collapses.

How regulators should respond to bubbles

A more nuanced understanding of bubbles complicates conventional thinking in areas such as securities law and financial regulation. Legal scholars and policymakers often assume that markets should pursue fundamental efficiency, meaning asset prices should closely reflect rational expectations about future cash flows and bubbles should not arise. But some degree of irrational enthusiasm may, in certain circumstances, generate social benefits.

The law should account for these distinctions by protecting citizens and the broader economy from destructive bubbles while allowing constructive ones to produce useful investments. Traditional macroeconomic tools, such as interest rate changes, are blunt instruments. They affect the entire economy and cannot easily distinguish between productive and harmful speculation. More targeted intervention is needed.

Legal rules can either encourage or restrain bubbles, and they can either smooth or complicate the recovery process after a crash. They also give policymakers and regulators tools to make fine distinctions, supporting valuable investment while discouraging wasteful or dangerous behavior.

First, legal reforms should guide early speculation toward promising opportunities while reducing the risk of the wrong kind of bubble. Financial regulation could aim to make financial institutions and systems more stable and less likely to generate speculation on their own. Instead of acting as independent engines of new bubbles, they should support investment tied to real economic developments. Policymakers could impose limits on certain financial products, such as binding debt-to-income caps for mortgages or restrictions on cryptocurrencies, and expand regulation to cover a wider range of money-like securities.

Ideally, these rules would operate automatically, directing market enthusiasm toward genuinely productive projects rather than requiring officials to identify good and bad bubbles in real time. Public policy can also strengthen the ability of private markets to make those distinctions. Competitive markets help identify valuable products and cost-efficient production methods, and strong antitrust enforcement can support that process.

Second, legal reforms should limit the effects of bubbles as they expand and as they affect the real economy. Stronger disclosure rules can reveal when promising business strategies are failing to deliver results. The law should also reduce the risk that bubbles distort investment in critical industries or expose ordinary investors to excessive harm. For example, the rush to build AI data centers could strain electric utilities without careful safeguards. Similarly, introducing risky new asset classes into retirement accounts could transmit the pain of a collapsing bubble to ordinary households.

Third, legal reforms should manage the adjustment process after a bubble bursts. Financial market rules can help prevent a sudden collapse from immediately damaging the real economy, giving businesses and policymakers time to respond and preserve the valuable parts of the boom. Countercyclical capital requirements for financial institutions can ensure that firms have reserves available during a crisis. Governments can also help restructure industries after a bubble by financing transitions, reorganizing companies or moving sectors into more stable regulatory frameworks.

As enthusiasm pushes AI and cryptocurrency valuations to exceptionally high levels, a more careful analysis is urgently needed. Speculation can serve useful purposes, and it would be a mistake to suppress private initiative in favor of government-directed priorities. But not all bubbles are constructive. Policymakers must be prepared to protect workers, consumers, small investors and taxpayers from the damage that bubbles and their aftermath can cause.

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