Man Without Qualities

Tuesday, July 29, 2003

Mania, Panic, Crash

My father would occasionally wisely counsel me with the old nostrum: Son, if you can keep your head while all about you are losing theirs, you probably don't understand the problem. It would be a good idea to keep that nostrum in mind while reading a review of the life of Charles Kindleberger - a good, now physically defunct, economist - in the Economist magazine, which muses:

Perhaps more interesting has been the reaction of those most loth to abandon rational Homo economicus. Only a few old believers cling to the idea that the rise in dotcom share prices genuinely reflected likely profits, and that their sudden plunge was caused by regulatory (in)activity. Most prefer to ask why informed, rational investors failed to arbitrage away the absurdly high prices caused by irrational buying, as efficient-markets theory predicts.

What accompanies is a partial list of non-rationalistic and "market failure" approaches that have been tendered to explain the "dotcom bubble" - including the inevitable reference to “behavioural” economics. But the article's best quote is from Peter Garber: “Academics increasingly say there is a bubble as a substitute for thinking hard about the fundamentals of security valuation.”

Well, like the Marines, the Man Without Qualities vows to leave no rational Homo economicus behind! I don't think the dotcom run-up was much of a bubble. So allow me to cling - if not to the odd misstatement (or at least "misleading" statement) of rational economics proffered by the quoted language, at least to a concept more focused on investors buying discounted future profits than those appearing in the article's list. By way of background, I note that a Man Without Qualities a post written some time ago promised to return to the question of whether the dot com run-up was, indeed, a "bubble" in the sense that it was dependent mostly or entirely on "greater fool" buying and selling. This post is an attempt at that long-delayed return.

Unfortunately, I have to base my analysis on anecdotal evidence. I have not located any good systematic study attempting to ascertain what dotcom investors thought they were doing during the run-up (efforts of "behavioral" economists known to me are not to the contrary - despite all claims). Considering the amount of money involved, the effects on the economy and all the shouting about whether the dotcom run-up was or was not a "bubble," that is perhaps surprising. But, then, it is constantly remarkable that the participants in many big-time social science shout outs prefer to exercise their lungs rather than actually do hard research. A situation similar in at least that respect is the topic of a New York Times magazine article on the infamous and 100-year-old topic of repressed traumatic memories, as described by a researcher who actually did some research and of course got into hot water for doing it: ''You had two groups in opposite camps that were battling each other out'' over the validity of recovered memories, Clancy says. ''But nobody was doing research on the group that was at the center of the controversy -- the people who were reporting recovered memories. Memory function in that group had never been examined in the laboratory.'' Returning to the dotcom-as-bubble question, if somebody has actually spent time out of the sun checking the relevant central facts, I would be pleased to hear about it.

I believe that much of the dotcom investor belief in the dotcom (or internet) sector was rational, although much of it may have been mistaken. Generally, economists cannot re-run experiments as, say, a physicist or biologist can. Which means that economists are often reduced to more imperfect “tests” of their hypotheses. And those tests often confuse "rational belief" with "correct prediction." How can an economist - or anyone - reliably distinguish between a stock run-up based on a rational but false belief from a stock run-up based on irrationality? [Is it a coincidence that many of those who most easily believe in irrational "bubbles" seem (anecdotally) often to be people who easily pass from the observation "we have discovered no weapons of mass destruction in Iraq" to the conclusion "those who asserted there were weapons of mass destruction in Iraq must have been lying?"] There is no easy answer to that question - and that gap allows for a lot of bad economists to propose easy, seductive "irrational" or "bubble" hypotheses for which certain actors in the media and politics have an unhealthy appetite. By way of example only, John Kenneth Galbraith was an especially bad specimen of this species of hyper-articulate, bad, economist - a man who produced a seemingly unending series of such wonderful, awful ideas.

One way to distinguish some "rational false belief" run-ups from "bubbles" might be to examine the subjective psychology of the investors involved, since many (but not all) "bubble" arguments seem to involve a segue onto such terrain. The dotcom run-up was not accompanied by the general euphoria the normally accompanies bubbles - which of course suggests that the dotcom run-up was not a bubble at all. Of course, in Silicon Valley, certain niches on Wall Street and some pendant venues there was general euphoria - but that's not the relevant investor population. For one thing, the denizens of Silicon Valley spent the money, they weren't the source of it (it was said - mostly by people who don't understand the mechanics modern securities issuance - that Silicon Valley's main export was paper, as in the paper supposedly used to print stock certificates). In fact, during the dotcom boom, a large cadre of highly qualified and articulate investment professionals always and loudly preached that the whole thing was a stupid and expensive mistake. Value fund managers and "old economy" players were also squeezed, and they howled and expressed their skepticisms, too. Yes, each such skeptic was dismissed by dotcom investors with the aplomb all-night revelers at a West Hollywood club might use to dismiss a Calvinist preacher: "They just don't get it." But the dotcom run-up swam against a substantial and broad counter-current. What were dotcom investors expecting?

During the run-up I found it never hard to make even a committed dotcom investor admit that almost any identified dotcom company - even one in which the investor had just invested - had a business plan that made as much sense as the plot of a 1930's screwball comedy or the then-most-recent Clinton Administration plan for dealing with North Korean nuclear weapons. There were a few exceptions, such as Amazon and AOL, where a wide class of investors seemed to actually, subjectively, think that spectacular profits for those particular companies were within reach, although even with those companies there were plenty of nay-sayers bearing what could have been highly persuasive arguments. Why did those arguments not persuade more people, especially people who readily admitted that most dotcom business plans were loopy?

Well, because if confronted with weaknesses in particular investments, dotcom investors generally moved to a broader argument: Yes, this particular company you criticize has a loopy business plan ("Pets.Com" or "eToys.Com" or whatever). But, after all, in a classically competitive market any single, particular company has measure zero. While I may not believe in any particular dotcom company, I do believe that the internet is coming, and I hope that one or more of the stocks I buy for my portfolio will connect with that future. Such dotcom investors were certainly not expecting "likely profits" (as the Economist puts it) from any particular stock - but they were investing with a belief in a very unlikely but positive chance of an enormous return from at least one stock. In that sense internet investors may have been very rational in their diversified-up-to-the-sector approach to investing. Within the dotcom sector, investors were usually saying that they admitted to an almost complete inability to distinguish good business plans from bad.

But relocating the source of dotcom investor willingness to invest in their belief in the dotcom (or internet) sector still means that one has to ask: was that belief rational and, in any event, why did it end?

In brief: The belief of dotcom investors in those investments seemed to be based on a broad belief that the internet would permit widespread disintermediation of many middlemen (sometimes replacing them with much more efficient internet middlemen), as well as the elimination of whole classes of free riders and especially elimination of much regulatory and tax drag. In this sense, the dotcom run-up partially concealed a striking political agenda: the regulatory and tax drag that held the "old economy" to a growth rate of, say, 3% would give way - and a "new economy" freed by technology from regulatory and tax drag would boom along at, say 7% growth for the indefinite future. Instead of physical book stores, for example, that would be plagued by local taxes, local utility rate gouging, union demands, historical societies imposing design restrictions, and so on - Amazon would exist "nowhere," free from all that. Many of the "free riders" and "intermediaries" that bog down commerce and growth were thought to be eliminable. The famous de facto elimination of sales tax for e-tail purchases fed the belief that this political structure could maintain itself.

Again focusing on the psychology of dotcom investors: Developments in the Microsoft anti-trust case played a pivotal role in reversing dotcom investor confidence - an effect which clearly occurred but is not well understood. But the image of a no-neck federal judge, a creature from the briny depths of the old economy, reaching out from the beltway in a serious attempt to demolish the most successful technology company in history on the basis of flaccid, efficiency-reducing legal theory, seems to have put the brakes on investor confidence that the internet sector could avoid the regulatory and tax drag that holds down the "old economy." Once that investor confidence was gone, some of the most important rational underpinnings of the dotcom run-up collapsed. The Microsoft anti-trust action was justified by the urgent argument that Microsoft had leveraged itself into a commanding control position of the exact same hyper-profitable internet-dominated future on whose arrival the “irrational” dotcom investors were relying. The anti-trust action has quietly and gradually subsided into the bogs of intellectual embarrassment in which it belongs. But if the dotcom investors were “irrational,” how could the Microsoft action not have been “irrational.”

Were those investor beliefs "irrational?" Well, there are still smart people who argue that unauthorized downloading of music (and, presumably, other intellectual property) from the internet is both good for the economy and cannot be stopped by the government or private parties. Perhaps the internet will eventually gnaw through more of the "old economy" regulatory fabric. And, yes, recent history has shown that most of those dotcom investors were making some big mistakes, at least as to the timing of the arrival of an internet-dominated future and the prospect that a particular dotcom portfolio might contain at least a few winners, or at least survivors. But making mistakes is not in itself irrational. Some dotcom business plans have now materialized or evolved that seem to at least have a reasonable prospect of making reasonable profits, Amazon and especially e-Bay being the currently best known examples. But it is certainly not irrational for investors to misjudge the date a particular technology will transform the economy. I wonder if, say, ten years from now, the retailing sector has become mostly internet-based, if many people will be arguing that the dotcom run-up was a "bubble" - or just a premature guess? Isn't it too early to tell?

Further, while there surely was substantial "greater fool" trading, especially towards the end of the run-up, there is always "greater fool" trading going on in the market - every "momentum fund" is arguably based on that process. And, yes, there was too much liquidity in the market - a "money bubble." The Fed had increased the money supply greatly. But a focus on the money supply and general liquidity cannot answer the question: Why did that money go so much into stocks - especially internet stocks, instead of, say, housing, as has more recently occurred? While "greater fool" trading and liquidity effects were exaggerating features of the dotcom run-up, they do not seem to have dominated it.

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