Trying to determine the next economic bubble is an unfortunate reality in America’s current economic environment. It has become a consideration when deciding whether or not to enter an industry either in a career or as an investment opportunity. However, this wasn’t always the reality. Although economic bubbles have always existed, in the last 25 years or so — from the savings and loan crisis to the dotcom bust to the real estate bubble — they have become more commonplace.
Now that this determination is part of any due diligence, it is vital to understand the characteristics of a bubble in order to help identify the next one. I have some of my own thoughts about the creation of bubbles, including limited barriers to market penetration, perverse federal policy and the speedy entry of financial resources. But for this analysis let’s turn to an expert, Hyman Minsky, and his Theory of Financial Instability.
According to Minsky, there are five elements to any bubble scenario. First, in the displacement stage, a new entity piques investor interest. Second, the boom stage ensues as prices and participants begin to rise. The third characteristic is euphoria where investors create justifications for increasingly higher market prices. Forth, the participants see a profit taking opportunity and money begins to leave the market. And last, the panic sets in when prices fall dramatically and investors sell out to protect against financial ruin.
I believe the emerging pot industry is protected against this phenomenon — for now.
The most important factor protecting the marijuana industry from economic bubble status is a conflict of laws. Conflict between federal prohibition and state legalization measures will allow the industry to grow at a reasonable pace, as large scale financial and insurance institutions will hesitate to support investors in a federally prohibited industry. Although the marijuana industry is not lacking financial resources due to private and venture capital money, creating a economic bust similar to the dotcom or housing market will require a much larger influx of financial resources and participants. Without legalization on a federal level, that influx is unlikely. Legal conflicts impose a scaling problem on the industry, limiting its growth. However, in the long run, those limitations may be exactly what create a lasting dynamic.
Additionally, the incremental implementation via a state-by-state federalism approach will allow the industry to learn from mistakes and determine best practices. Moreover, state governments will be able to study different implementation methods, as they already differ on how to regulate a nascent marijuana industry. Federalism also has the benefit of limiting federal policy intervention. Although the federal government has not yet determined how to proceed, it seems likely they will leave this issue to the states. And by limiting the invasion of federal policy through true federalism, there is less of a chance for broad, top-down policies to facilitate a bubble environment.
Finally, the American marijuana industry is not new; it is just legal now. For decades an illegal market has existed, resulting in some of the highest rates of pot smoking in the world. While new rules and regulations will affect the existing market, many of the early participants will have experience and knowledge to apply to the new, legal pot start-ups. Furthermore, we already have industry models illustrating how to produce, market and sell vice products. Both the alcohol and cigarette industry are longstanding and thriving examples to those entrepreneurs exploring the marijuana economic landscape. In fact, the cigarette industry already has thoughts of applying their model to this newly legal substance — although they wont admit it. Longstanding demand, cultural knowledge and existing business models will help the marijuana industry develop sustainably over time.
Even though I don’t see the emerging recreational marijuana industry as the next great American bubble, that doesn’t mean the industry will not experience its share of failures. That is part of American entrepreneurialism. Limited resources, other industry examples and Federalism can only safeguard an emerging industry so much; investors and other participants will inevitably assume too much risk and make costly mistakes. However, I do see an increasingly strong industry as more states legalize marijuana. But once this becomes a federal issue and large-scale investors get involved all bets are off.