Tim Cavanaugh at Reason, observes that the peak of the dot-dom bubble was reached ten years ago today. The dot-com bubble and other technology bubbles are often held out as examples of the irrational nature of market economies by those who think they could do a better job of running the planetary economy than the rest of us can.
This is myth. Booms and busts represent two equal and necessary phases of technological development. A bust looks ugly but so does the birth of child. The busts are every bit as necessary as the booms and every bit as good for the general society and economy.
I am a student of technological history and the dot-com boom/bust followed a pattern that has reoccurred since at the least the beginning of the Industrial Revolution.
(1) When a new technology reaches a certain level of development, it becomes universally recognized as a game changer (e.g., trains circa 1850, cars circa 1920, aircraft circa 1930, plastics circa 1955, computers circa 1985, the Internet circa 1998).
(2) A boom happens as venture capitalists and established businesses pile into the new technology like the Three Stooges trying to get through a door at the same time. In the great aircraft boom of the late-1920s to 1939, everyone from shipwrights to car makers to furniture makers tried their hands at building aircraft. Ford was the largest single producer of aircraft in America till the end of WWII.
(3) This period results in an explosion of diverse variations on the central technology. The majority of them are in hindsight just plain silly. Look at a Byte Magazine circa 1984 and just see how many hundreds of computer hardware platforms there were. Now we have two with a few variations.
(4) After the boom there comes a bust. The bust is caused by the results of market selection winnowing down all the variations to a handful of optimal forms. Most of the companies in the market go out of business or are absorbed by larger and more successful companies.
(5) We all get treated to endless moralizing by everyone from ministers to economists about how the bust demonstrates human folly and how we all need either God or the government to save us from ourselves.
(6) While the moralizing goes on, the supposedly busted technology sector becomes a dominant economic player of such magnitude that no one can image the world without it.
(7) Some new tech comes along and the cycle repeats itself. Right now, I would say we’re just at the Three Stooges-versus-the-door stage of the mobile computing device boom.
Far from being a moralistic tale of human greed and economic hubris, the boom and bust of new technologies is part of creative evolution. As much as it pains our egos to admit it, the only way that we even know is something will work or not is to try it and see. Technology booms are the economic version of the scientific method. We should no more sneer at failed investors, businessmen and inventors than we sneer at scientists who test and destroy their own hypotheses.
Most dot-coms failed because they were experimental and most experiments will fail. If they didn’t, we wouldn’t call them experiments, we would call them, let’s-do-that-thing-we-already-knows-works-iments.
We should venerate all those idiots at Pets.com, Flooze.com, Koop.com et al as the sacred fools of an empirical market economy. Thanks to them, we know what does and does not work.
No boom, no bust, no progress.
There are other factors in bubbles. A several economists who specifically study bubbles have independently reached the conclusion that bubbles are more likely to happen in markets where shorting is too expensive or impossible.
The United States via SEC imposed trading rules puts a lot of upward bias into the market. This, in turn, creates a more volatile boom and bust market.
What Shannon describes is a market with fat tail price distribution. In other words, where nobody is sure how to value the new technology because it is unprecedented. That kind of uncertainty more easily leads to mass overvaluation.
We are treated to the moralizing Shannon describes by politicians only as an argument to convince us that we must willingly strip ourselves of our liberty and hand over the reigns of control over our personal lives to them. How repulsive.
How preposterous is it for a politician to claim that he and his small group of politicians in his party knew more than the hundreds of millions of people who participated in that tech market? That is akin to likening yourself to God. And that’s exactly what politicians do.
This same process happened with the boosterism and booms in the 19th Century, based on locations rather than technologies. Everyone piled into Australia or Texas or Oregon, etc., knowing something big would happen, unsustainable growth rates occur, there is a big bust-up, and the new territory settles down to a few viable industries that allow it to export something of value, and more measured growth follows. The recent book by Belich of Replenishing the Earth: The Settler Revolution and the Rise of the Angloworld, 1783-1939 covers this, though he tends to come down on the side of human stupidity and gullibility as the great engine of change. He’s wrong about that. These are discovery processes, and there are no shortcuts.
To expand on what Methinks and Lex wrote, the word “bubble” as used casually refers to two different patterns of events, which the media and politicians, in particular, tend to confuse. One of these patterns is mass-experimentation where investors throw capital at numerous business experiments, most of which fail. The other is the pure speculative bubble where capital, often encouraged by govt policies that distort incentives, gets invested in an asset class to the extent that it drives up prices substantially, but without contributing to overall productivity. The dotcom investment boom contained elements of both of these patterns. However, ten years later, the fact that the surviving companies (Amazon, eBay et al) are thriving and have numerous direct competitors supports the theory of the dotcom boom as a winnowing process. The recent real-estate boom is mostly an example of the other kind of bubble, because it probably wouldn’t have happened without politically created market distortions that over-incentivized home buying. Unlike the dotcom boom it did not lead to productivity increases that leave us better off overall.
I agree that the left/right moralists are destructive. The leftists use busts to rationalize bigger govt, less freedom, and crackdowns on risk taking. The rightists, and some of the leftists as well, use busts to demonize debt. Risk and debt are central tools of economic growth. Trial and error, including failure and sometimes failure on a large scale, are necessary parts of the process.
Like the final phase of a bull market, the bubble involves a flight from reality by investors and potential investors. Who could believe that pet food could be profitably delivered from internet orders ? I personally looked at houses in Orange County CA where I live that were unbelievably overpriced. I can still remember one instance where I fell for the delusion. It was when the Hunt brothers tried to corner the silver market. My wife and I had a certain pattern of silver flatware in our home and I convinced myself that the price would never come down and so I paid four times the usual price per place setting. It was sort of like hoarding in that we didn’t really need the extra place setting but I was convinced the price was going to continue to rise. Of course, a year later, the price was back down where it should be and I learned a lesson at a modest cost.
I see an awful lot of people who learned that lesson at a much higher cost.
As Jonathan said, bubbles result from both popular mania (bottom up) and government intervention (top down). From your examples I can say that government helped inflate at least tow of those historical bubbles: trains and planes. If I knew more about the others I wouldn’t be surprised to find government magnifying popular manias there either. [I don’t count the dot-com bubble as historical, I was inside it]
I don’t mind when investors lose their shirts or win a yacht – it’s their shirt or yacht. I do mind when the government bets other peoples money in the same fashion. I live in Massachusetts and the state has graced the biotech industry with a billion (with a “B”) dollars in tax breaks for moving here. If the legislature was really so certain that the billion would make money they would immediately quit the legislature and run an angel fund.
NB, I’d add that the government contribution is sometimes structural (monetary inflation) and sometimes just a legislative alternative to the popular mania (e.g. the biotech thing).
My elementary econ textbook uses the term “infant industries.” The beginning of the industry learning curve has a high casualty rate.
The comments here are very sensible as usual;this blog is a pleasure to read, but I am feeling grouchy and pedantic.A king reigns over his realm; a rider reins in his horse, or controls his steed with the reins.
I have seen this error a lot in the past few months, all over blogistan-it is easily avoided.
Booms and busts are part of doing business, but this current one has been a catastrophe,a catastrophe that would not have been possible without the gov’t’s encouragement of unsound banking practices. Those banks that made unsound loans had no trouble getting permission to take over other banks; those who with sound practices were “racist” etc,etc.
Renminbi,
I was talking about tech booms. Financial bubbles are sometimes created by innovations in technology or financial practices but most commonly they occur because of government market distortion.
Financial markets have no significant material component so they adjust much more rapidly to changing conditions than do markets based on material products. Therefore, they should autocorrect much faster. Direct or indirect government manipulation of the financial markets is usually required to produce a significant bubble.
By contrast, governments have an abysmal record of trying to manipulate technology. Government efforts to promote technologies usually fail. The only real successes have been related to military technology and only then when the spending is on a massive scale such as with WWII or the Space Program. The government spending has to be high enough that it creates the entire market itself.
Point taken. In the 50s Air Defense Command had interceptors armed with 2.75 rockets (un-guided)- they probably would have had to ram to bring down Soviet bombers. The guided missile cruisers probably wouldn’t have worked either from what I heard from those aboard them. One has to have worked for gov’t to understand the general level of incompetence.
Financial markets have no significant material component so they adjust much more rapidly to changing conditions than do markets based on material products. Therefore, they should autocorrect much faster. Direct or indirect government manipulation of the financial markets is usually required to produce a significant bubble.
Shannon,
I don’t think we can say this definitively. Certainly, financial markets certainly are influenced by distortions created by trading restrictions which create upward bias and aid in the creation of bubbles. However, I don’t think we can definitively say that without such distortions bubbles in financial markets would not be significant.
For instance, when a new technology is introduced, the financial market tries to guess its impact. Since the technology is new, the range of valuations is very wide and it’s possible for a significant number of market participants to overvalue the new technology. However, as you point out, the correction can be very quick when it comes.
Methinks,
Although tech bubbles like the dot-com bubble do create financial bubbles as a side effect, their size tends to be relatively small compared to bubbles produced by manipulation of the financial system itself. The popping of the dot-com bubble didn’t trigger a single quarter of recession. It hit a lot of wildcatting investors hard but most people where unaffected.
Shannon,
In general, a good article. While I may disagree with the years given on some of the technologies, your observations cover most of the salient feature of tech boom and bust (you missed Watt in the early 1800’s).
My differences besides dates concern 2 things. Human Nature and the inability to perceive what is successful and how long success takes. For me human nature trumps all other effects. A boom/bubble is powered by the realization that wealth can be made doing some things. The plethora of technologies and business models through the centuries supports that. The main difference (although to this time , I think it is small) Is that we don’t know how long it will take. I worked with a colleague how looked at his company’s record of invention and found a 7 year lag between what was invented and developed and when it ended up as profits on their books.
Recent technology has conditioned us to expect quick (not immediate ) gratification. Sometimes we can’t see good opportunities in front of us because we are so focused on immediate gratification.
Human nature always triumphs.
Engineers (yes, that’s me) see this sort of thing all the time. This is a classic PID controller response (overshoot==bubble) to a big input change (new technology). There’s always overshoot because there is no knowledge of the underlying system’s properties built into the controller. It just responds to outputs. SEC rules, such as methinks mentioned, are like the controller parameters. Some make it more responsive, but there is more overshoot. Some reduce the overshoot but at the expense of making it sluggish to respond.
In engineering systems, if we learn about the system and discover the underlying basis for its response we can build that into the basic PID controller and get one that responds quickly, yet with no overshoot. That’s the ideal situation. I suspect that knowledge of economic principles, if they were to became more widespread within the community, would have a similar result. Perhaps bubbles aren’t inevitable.