Man Without Qualities

Saturday, March 16, 2002

Just What Was All That Dot Com Shouting About? II

As noted below, Max Power has posted excellent comments on my discussion of the effects of suppression of Blue Sky commission powers on the dot com stock run up. He has now supplemented that with a second post, which is also well worth reading. This post addresses some of the issues he raises and includes some additional material. The discussion doesn't purport to answer Max point-for-point. But many of the issues addressed below are derived from his arguments.

Federal Reserve's monetary policies. Explaining the dot com run-up means explaining why this sector was favored by investors over other sectors. The Fed’s monetary policy does not particularly target sectors of the economy, certainly not in a way that directly favors the businesses of hi-tech, start-up companies. So Fed policy cannot explain why investors chose to bid up the tech sector (largely reflected in the NASDAQ/NMS) far beyond other sectors of the economy.However, the Fed’s policy certainly could have been a factor in getting liquidity into investor’s hands to give them the opportunity to choose among sector investments.

The dot com run up was better for the economy than investment in blue-chips and real estate. This is possibly correct, but doesn’t help explain why investors chose to bid up the tech sector.

Value investors cleaned up. This is certainly not true in the short run during the run up. In the long run through the present it is true in a sense, but also doesn’t help explain why investors chose to bid up the tech sector. Quite the contrary it raises the question of why so many investors were so wrong.

Simply put, people wanted to invest in the Internet in 1998-2000. Well, OK. But why? This isn’t so much an explanation of the internet run up as a restatement of the fact that it occurred.

The Blue Sky commissions would have made no difference. This is the real heart of the matter. I think this question unpacks into a series of questions addressed below.

The Blue Sky commissions never had the power to make a difference. As a matter of sheer regulatory power, it seems the Blue Sky commissions could have had a big effect on a sector of stock if they so chose – absent the effects of the reforms culminating in the 1996 passage of NSMIA. Merit review laws spring from the Uniform Securities Act of 1956, which almost forty states have adopted. Of these states, Arizona, Arkansas, California, Iowa, Massachusetts, Missouri, Nebraska, North Carolina, Ohio, Oklahoma, Tennessee, Texas, and Wisconsin apply the “merit” standards most strictly. If the Blue Sky commissions of these even these “strict” merit states – or even one or more of the larger of them – had adopted and advertised policies widely disapproving stock offerings with the characteristics of internet offerings, it seems likely that the viability of such offerings would have been seriously impaired. Moreover, the states have made efforts to coordinate their Blue Sky review processes.

Blue Sky commissions did not stop the biotech “bubble.” The biotech “bubble” of the 1980s was arguably a reasonably close analogue to the dot com run up - except for its pervasiveness. But if the biotech “bubble” was otherwise similar to internet “bubble,” then the fact that the Blue Sky commissions had more power during the biotech “bubble” than during internet “bubble” is consistent with the Blue Sky commissions having a significant role in containing the pervasiveness of the biotech “bubble.” Blue Sky commissions were very active in disapproving of what they deemed to be “speculative” technology stock issues of all stripes – including biotech issues. It is exactly that intrusive activity of the Blue Sky commissions that led to the chorus that they were a big burden on the ability of technology companies to raise capital that led to the decade of reform ending in 1996. Critics of the Blue Sky commissions can’t have it both ways. Either they had a big effect on the ability of companies to raise capital or they didn’t. For years the critics persuasively – and, I believe, correctly – argued that the Commissions were a much bigger obstacle than just creating the need to hire and pay local counsel.

What is a “bubble?” References to the biotech “bubble” throw into high relief the question “What is a “bubble?” A “bubble” is by nature irrational, at least in the sense of what are sometimes called “fundamentals.” In general, a “bubble” includes a heavy dose of “greater fool” investing.

There is nothing necessarily “irrational” about investing in a stock on the belief that a “greater fool” will buy it later – but such investing is “irrational” on the fundamentals. In that sense, completely rational players but irrational fundamentals investors can drive “bubbles”. “Greater fool” players are not counting on the company in which the investment is made paying off, although they are counting on the investment paying off.

I do not believe that the “biotech bubble” is a good example of a true “bubble.” The biotech stock run up was based on the discovery in the late 1970’s of a series of techniques which even very smart scientists and businessmen working very close to the underlying research thought would have astoundingly beneficial (and astoundingly profitable) medical consequences.

Consider Biogen, solely as a representative example. Walter Gilbert, a Harvard professor and Nobel Prize laureate, withdrew from academics to found Biogen for the purpose of exploiting (particularly in the areas of interferon and hepatitis vaccine) what he and his ultra-sophisticated pharmaceutical company investment partners thought would be a fairly straightforward application of his prior research techniques. They also believed that with the cash flow from the original products Biogen would be able to fund the creation of a whole series of similar products. All of this was highly rational, both from a scientific and from an economic standpoint. But much of it turned out to be wrong. Indeed, Biogen almost collapsed, Prof. Gilbert was essentially forced out, and Biogen’s most important product by far resulted from the unexpected discovery that interferon is the best treatment for multiple sclerosis, a discovery which was not anticipated by Professor Gilbert or others at the time Biogen was founded. Indeed, it is still not even understood how interferon works in this treatment.

More generally, the biotech boom did not involve extended “greater fool” trading because that boom never reached the scale required. Economically rational bets that turn out to be wrong are not “bubbles.” Such bets are exactly the stuff of advanced capitalism and they are very good things – although the people who lose their money may not feel that at the time. Moreover, the biotech industry in general is thriving – and promises to eventually become at least as profitable as was hoped by its boosters in the 1980’s – albeit on a greatly extended period of return.

In a later post, I will argue that the significance (for good or ill) of securities regulators like the Blue Sky commissions probably arises where “greater fool” investing plays a larger role in moving the securities market involved. For now, I think it is worth noting that the biotech and internet run ups do not appear to be similar in this respect. That may undermine the significance of my observation that their similarity supports the importance of whatever differing factors one can locate (such as the intervening collapse of Blue Sky authority). So be it.

Lots of people were warning that dot-com stocks formed a "bubble" in 1999. It is undeniably true that the dot com run up had lots of critics while it was in progress. But the Blue Sky commissioners had the power to stop securities sales which, say, Paul Krugman does not – thank God for small favors. Many people seem to agree that Judge Pennfield-Jackson’s actions in the Microsoft case had a serious effect on the hi-tech stock markets. I agree. But it wasn’t because the Judge is a brilliant economist or jurist, quite the contrary. He was and is a no-name. Indeed, he appears to be no-neck. But his impact is widely acepted.

I believe that the Judge’s influence is connected with the second factor that interests me in the internet stock run up: a curious “hidden” political/economic expectation that the internet represented a means of avoid the costs of the regulatory state. The second factor will be the subject of a later post.

Nobody cared about what Alan Greenspan said, so some no-name commissioners wouldn’t have added much. It is true that Alan Greenspan at one point criticized the "irrational exuberance" of the securities markets. But he later relented, and actually became a proponent of the belief that the economy was becoming more efficient and could sustain those "irrationally exuberant" stock prices if this “asset inflation” didn’t inflate the rest of the economy through some ill understood “wealth effect”. In any event, Mr. Greenspan focused what criticisms he had on the aggregate stock market – not on any irrationality of the internet stocks. And he didn’t try to talk the tech markets And he didn't have the power to stop stock sales.

Multiple regulatory schemes were a drag on the economy. This is probably true, although it is oddly contested in the academic literature. Assuming it is true, then elimination of the drag should have encouraged more investment in areas freed from the drag. This factor therefore suggests that elimination of the Blue Sky drag did help boost stock prices (rationally). Moreover, the drag was likely greatest in areas of the economy in which the Blue Sky commissions were most disapproving – that is, “meritless” stocks. To the extent this factor is material, it supports both the proposition that eliminating Blue Sky review boosted stock prices generally and the proposition that such elimination disproportionately boosted dot com stock prices compared to the market generally. In fact, a good deal of academic research indicates that, from their beginnings , “The blue sky statutes … [o]n average … put the most stringent restrictions on high-risk (and potentially high return) securities.”

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