Dot-com bubble

The Dot-com bubble or IT bubble was a dramatic boom-bust cycle of the American economy during the years 1995–2002.

The height of the boom was characterized by enormous increases in stock prices, and especially the prices of Internet-related assets. The bust saw the rapid decline of most of the same prices. The Internet companies whose share prices were bid up came to be known as "dot-com" companies, from the common Internet domain name extension, ".com." In addition to the stock market bubble, the period in question saw increasing consumer leverage, a booming housing market, increasing debt-to-equity ratios, and lower down payments on homes. The turn that came in 2000 triggered the liquidation of boom-inspired malinvestments. The Federal Reserve attempted to engineer a "soft landing" with a moderate tightening of credit conditions. By the end of 2000 the NASDAQ slid to 2471 from the March peak of 5048.

Background
The boom began against a backdrop of generally improving economic conditions in the U.S. in 1993 and 1994. The Plaza Accord of 1985 had improved the profitability of U.S. manufacturing, as the G-5 powers agreed to subsidize U.S. exporters by artificially lowering the exchange rate of the U.S. dollar. (One author identifies the Plaza Accord and the accompanying monetary expansion in Japan as the beginning of that country’s own boom and bust.) The American economy had come out of the recession of 1990–1991 in fair shape, with some of the misallocations of the 1980s boom having been corrected. It seemed investments in information technology were finally paying off, and manufacturing productivity was increasing. The stock market began to climb in 1993, and the recovery looked robust enough that the Federal Reserve began to raise rates.

But, beginning with the Mexican crisis and bailout of late 1994 and early 1995, the Federal Reserve was faced with a series of financial collapses. Over the rest of the nineties, the Federal Reserve oscillated between halfhearted attempts to restrain the equity boom and responding to crises that it believed called for reversing the previous restraint. In the meantime, theories of a "new economy" developed, both inside and outside the Federal Reserve, to justify soaring asset prices.

The "Reverse Plaza Accord" was an important factor in creating the late nineties boom. By that agreement, the big three powers (the U.S., Japan, and Germany) bailed out a Japanese manufacturing economy that was slowing to a halt under the pressure of the record-breaking ascent of the yen. They did so by engineering a striking reversal of the steep decline of the exchange rate of the dollar that had taken place over the previous decade.

Japanese manufacturing firms were faltering in 1995. "By April 1995, the yen had reached an all-time high of 79 to the dollar. . . . With the currency at such a pinnacle, Japanese producers could not even cover their variable costs". Many Japanese banks were facing insolvency. The U.S. had just gone through the Mexican bailout, and authorities were not enthusiastic about having to face a similar bailout scaled up to the size of the Japanese economy. The Reverse Plaza Accord was, in effect, an agreement that the U.S., German, and Japanese governments would subsidize American consumers’ purchases of Japanese and German manufactured goods. The reversal of the exchange rate trend "was to be accomplished by lowering Japanese interest rates with respect to those in the U.S., but also by substantially enlarging Japanese purchases of dollar-denominated instruments such as Treasury bonds, as well as purchases of dollars by Germany and the U.S. government itself".

Driving the dollar up against foreign currencies would allow the U.S. government to maintain a stance of monetary ease without raising the CPI, since the artificially lowered price of imported goods would tend to counter the price-raising effect of the increased liquidity.

But liquidity has to go somewhere. One place it went was into the U.S. stock market. Another was into the asset markets of the East Asian countries whose currencies were tied to the dollar. The perverse effect of the flows was that, even as the manufacturing profitability of American and East Asian producers was undermined by the rising cost (in the yen and in various European currencies) of both their imported capital goods and their exported output, American and East Asian asset prices were given a further impetus upwards, as Japanese and European investors earned profits from both exchange rate movements and the rise of the American and East Asian stock markets in terms of the native currencies of those markets.

Given that some of the consequences of this policy appear obvious in retrospect, it is reasonable to ask what the thinking of the people who orchestrated the Reverse Plaza Accord was. The chief motivation seems to have been a desire to undo the previous distortions of the Plaza Accord, especially the decline of German and Japanese manufacturing, without too much pain.

IPO Boom
During 1994 and early 1995, the Internet had begun to enter the broad public consciousness. One of the most prominent companies involved in the transformation of what had been a chiefly academic network into a giant commercial phenomenon was Netscape. Three million copies of Netscape Navigator had been downloaded in three months after its initial release, "making it one of the most popular pieces of software ever launched."

The legendary Netscape initial public offering (IPO) occurred in August of 1995. When planning to take Netscape public, the price at between $12 and $14 a share was found too low, the quantity demanded far outstripped the supply of shares. Morgan Stanley raised the initial price to $28, valuing a fledgling, profitless company at more than a billion dollars. The day the stock began trading on the open market, the demand for shares was so high that the Morgan Stanley traders were unable to find a market-clearing price for two hours after the session began. When Netscape shares finally publicly traded, the stock was priced at $71. It closed the day at 58¼, a first day gain of 108 percent, valuing the company at $2.2 billion. As a commentator said, "Pretty much everybody involved in the IPO had gotten seriously rich."

The Netscape IPO served as a highly visible symbol for the potential of the Internet, and the potential investor profits that might be gained by arriving at the dot-com party early. A few company founders made vast fortunes when their companies were bought out at an early stage in the dot-com stock market bubble. These early successes made the bubble even more buoyant. An unprecedented amount of personal investing occurred during the boom, and the press reported the phenomenon of people quitting their jobs to become full-time day traders.

Monetary policy
In March of 1995, following the U.S. bailout of the Mexican economy (and holders of Mexican bonds), the Fed ended its credit tightening campaign begun about a year earlier, and, starting in July 1995, it quickly lowered rates by three-quarters of a percentage point. Meanwhile, the technology-heavy NASDAQ Composite began to rise rapidly, crossing 1,000 for the first time ever. The index rose over 27 percent in a 10-month period.

The Bank of Japan was easing over the same time period, cutting its discount rate from 1.75 percent to 0.5 percent. The policy of maintaining a large interest-rate differential between U.S. and Japanese central bank rates gave rise to the profitable "carry trade," whereby investors would borrow yen at low rates and reinvest at a higher yield in the U.S. The interest rate differential available from the carry trade, combined with the orchestrated rise of the dollar against the yen, meant that as long as the Reverse Plaza Accord held, investors were offered a nearly guaranteed profit by borrowing yen in Japan to invest in U.S. financial assets denominated in dollars. Such an arrangement could not but accelerate the rise in the price of U.S. financial assets. In addition, Asian governments became large buyers of U.S. government securities, helping to send foreign sales of U.S. government securities to several times the level of the early nineties. The already historically high $197.2 billion of sales registered in 1995 rose to $312 billion in 1996.

Even at full employment, the Federal Reserve can stimulate the economy, but the effect of such stimulation is temporary. Long-run considerations—of inflation and economic discoordination—warn against monetary ease in such circumstances. The duration of the seemingly positive but temporary effects of monetary stimulation—the "overheating"—is believed to be roughly 18 months. The most likely episodes of overheating, then, occur in the 18 months prior to a national election. This is the key implication of modern political business cycle theory and is consistent with the Austrian theory of the business cycle. The Fed cut the discount rate in late January of 1996. While a mild increase in the unemployment rate, whatever its actual cause, may have provided some "cover" for the Federal Reserve, there was widespread belief that its monetary tools were being wielded against the Republican party and not against the winter storms. The fact that the expiration of Greenspan’s second four-year term—and possible reappointment to a third term—fell in March 1996 added an extra element of politics to this particular political business cycle.

When the unemployment rate dropped further and further below the 5 percent level, Greenspan became receptive to the idea that the long-established full-employment range was no longer applicable. The apparent productivity of the labor force had ushered in a "New Economy." The similarity of that phrase to the 1920s slogan, a "New Plateau of Prosperity," seemingly did not attract the notice of the Fed chairman, despite the fact that in his youth he had studied and lectured on the Great Depression, employing the Austrian theory of the business cycle.

1997–1998: A time of crisis
A series of economic crises—in East Asia, in Russia, in Brazil, and in the U.S. itself with the Long-Term Capital Management failure and the potential Y2K problem—created a situation in which the Federal Reserve felt obliged to supply repeated influxes of liquidity to the market. As a result, after increasing at a rate of less than 2.5 percent during the first three years of the Clinton administration, MZM (money zero maturity) increased over the next three years (1996–1998) at an annualized rate of over 10 percent, rising during the last half of 1998 at a binge rate of almost 15 percent.

The problems inherent in the Reverse Plaza Accord first appeared in East Asia in early 1997. A significant portion of the enormous increase in liquidity worldwide, originating primarily from the American and Japanese central banks, had flowed into investments in that region. Between 1990 and 1995, 74.5 percent of capital flows to less developed countries went to East Asia. Governments there, operating on the mercantilist Japanese model of development, subsidized a rapid industrial buildup, often channeled into certain "strategic industries" such as high tech manufacturing. Because they partially funded the subsidies by borrowing in dollars, they were reluctant to loosen their pegs, as the cost of paying back dollar loans would increase in terms of the local currency.

However, "[b]etween April 1995 and April 1997, the yen fell by 60 percent . . . with respect to the dollar". If East Asian governments wished to maintain their peg to the dollar, they had to let their currencies rise against the yen as well. But that led to a steady rise in the price of their exports compared to those of their Japanese competitors. The East Asian countries had committed to the U.S. policy of subsidizing German and Japanese manufacturers and their own consumers at the expense of their own manufacturers. However, with smaller economies, manufacturing bases already distorted through extensive subsidies, and without being able to print the world’s reserve currency at will, East Asian governments lacked the ability to sustain such a policy as long as their American counterpart. Corporate profits declined throughout East Asia. In South Korea, for instance, they fell 75 percent in 1996, and went negative in 1997 and 1998.

When, one by one, the East Asian governments finally surrendered their pegs, the value of their countries’ dollar debt rose dramatically in terms of the local currency. The crisis in East Asia "steadily worsened . . . Throughout much of 1998, stock markets continued to fall and, as money flooded out of the region, currencies swooned, placing great pressure . . . on the rest of the world economy". The crisis spread to Russia in the summer of 1998, when it defaulted on its sovereign debt, much of which was held by U.S. investment banks. "The Brazilian economy started to melt down shortly thereafter". And Japan labored under a "hefty new value-added tax," which, along with other factors, "subtracted . . . the equivalent of 2 per cent of GDP".

The climax came on 20 September, when the huge Long-Term Capital Management hedge fund (LTCM) admitted to the authorities that it was facing massive losses. The Fed then made its three famous successive interest rate cuts, including one dramatic reduction in between its meetings. The Fed also encouraged U.S. Government Sponsored Enterprises— including the FNMA, GNMA, FHLMC, and FHA—to engage in a spate of lending (and borrowing) entirely unprecedented in their history.

The Federal Reserve, during a period of over a decade, had attempted to build a "firewall" protecting the "real" economy from Wall Street shocks. But firewalls work both ways: Protecting the real economy from Wall Street shocks also disconnected Wall Street from the real economy. Hedged on the downside by what could be called "Fed insurance" against falling asset prices, investing on Wall Street began to look better and better compared to investing in the messy "real" economy, where one might lose one’s money.

The Boom
By 1999, the liquidity party was in full swing. The rate on 30-year Treasuries had dropped from a high of over 7 percent to a low of 5 percent. The stock markets continued to soar. The NASDAQ Composite rose over 80 percent in 1999 alone. People who had stayed in the sidelines during the early part of the festivities began to feel left out. With abundant credit being freely served to Internet startups, hordes of corporate managers, who had seemed married to their stodgy blue-chip companies, suddenly were romancing some young and sexy dot-com.

It is possible to invest more and more if enough consumption is forgone to fully fund the investments being planned. However, during the dot-com boom, both investment and consumption exploded in the U.S. economy. Between 1950 and 1992, the personal savings rate had never gone above 10.9 per cent and never fallen below 7.5 per cent, except in three isolated years. But, between 1992 and 2000, it plummeted from 8.7 per cent to -0.12 per cent. By 2000, households’ outstanding debt as a proportion of personal disposable income reached the all-time high of 97 per cent, up from an average of 80 per cent during the second half of the 1980s. At the same time that consumers were saving less and borrowing more, businesses were increasing their capital spending.

The height of the bubble could, to some extent, be measured by the surge in number and decline in quality of IPOs, especially during 1999. The value of IPO offerings nearly doubled from 1998 to 1999 alone. Between 1986 and 1990, the San Francisco Bay area saw 90 IPOs, while between 1996 and 2000 there were 390. Before the second half of the 1990s, it was generally considered mandatory for a business to have had at least several profitable quarters before it went public. But by 1999, companies were going public with little more than a sketchy business plan, an Internet address, and a few twenty-somethings who could speak the right lingo. From June 1995 to March 2000, MZM grew 52 percent, well ahead of real GDP growth of 22 percent for the same period.

The stock market, especially the high technology NASDAQ, seemed to levitate as Y2K liquidity hit the market in late 1999 and early 2000. The NASDAQ Composite index moved from 2746 at the end of September 1999 to 5048 on March 10, 2000, an 83 percent rise in under six months!

During the final quarter of the year 1999, the Fed, in anticipation of a possible Y2K liquidity crisis, pumped sufficient liquidity into the banking system to bring down the Federal Funds Rate from 5.5 per cent to below 4 per cent—the widest deviation from its target rate in over nine years —and thereby paved the way for the last frantic, record-shattering upward lunge in the equity markets, which took place in the first quarter of 2000. Bank loans thus raced ahead at a 19.4 per cent annual pace during the fourth quarter of 1999, the highest in at least fifteen years.

By late 1999, production of business equipment was up 74 percent and construction up 35 percent over 1992, while production of consumption goods had risen only 18 percent. Among manufacturing goods, durable good production had risen 76 percent while nondurable good production had risen just 13 percent. Annual borrowing by nonfinancial corporations as a percentage of nonfinancial corporate GDP darted from 3.4 per cent in 1994 to a previously unparalleled 9.9 per cent in the first half of 2000. As a result, by the first half of 2000, nonfinancial corporate borrowing on an annual basis had more than quadrupled with respect to 1994 and nonfinancial corporate debt as a proportion of nonfinancial corporate GDP had reached 85 per cent, the highest level ever.

The personal savings rate declined from an already low 2.1 percent in 1997 to -1.5 percent by 1999. Consumers were increasingly leveraged, especially on their homes. In 1989, about 7 percent of new mortgages had less than a 10 percent down payment, according to Graham Fisher & Co., an investment research firm. By 1999, that was more than 50 percent.

The burst of the bubble
In the end, there were too few resources available for all of the plans formulated and funded during the boom to succeed. The most crucial—and most general—unavailable factor was a continuing flow of investment funds. There were shortages of programmers, network engineers, technical managers, office space, housing for workers, and other factors of production. Even industry giants like Microsoft, which did not rely on easy credit for their existence or for the bulk of their growth, were still forced to compete with companies that were relying on easy credit for access to the factors of production.

After the Y2K scare was seen to be much ado about nothing, the Federal Reserve renewed its concern about an over-heating economy and resumed its rate increases. However, even if the Federal Reserve had not tightened, sooner or later the wedge between savings and investment would have manifested itself in an absence of other resources. The rising prices of the factors of production would have brought the boom to an end eventually, whether or not the Federal Reserve tightened credit.

From the March peak of 5048, the NASDAQ slid to 2471 by the end of 2000. As bad as the general decline was, the drop in the dot-com stocks was even more precipitous. By the summer of 2001, the entire Bay Area was feeling the effects of the dot-com crash: "The number of technology pink slips handed out [in Silicon Valley] since the beginning of the year is approaching 200,000, according to various estimates, and the end is nowhere in sight."

The Bust
During 2001, the Federal Reserve demonstrated—with its 11 interest-rate cuts and a near-desperate MZM growth of over 21 percent—that it is difficult to recreate the previous evening’s euphoria in the midst of a hangover.

Maintained by waves of mortgage refinancing, zero-interest auto loans, and continued strength in the housing market, consumer spending stayed strong even as business investment faltered. However, an ominous debt shadow loomed over consumer finances, and record filings for bankruptcy have been logged.

The terrorist attacks of September 11, 2001, certainly delivered an unanticipated and unwelcome shock to the economy. However, the economy had already slipped into a recession by late 2000 or early 2001, and while the stock market quickly rebounded from its post-September-11th lows, most major indices sunk back below those lows a year later. By the end of September of 2002, the NASDAQ composite index had hit a 5-year low of 1173, down 77 percent from its peak in 2000. The Dow Jones Industrial Average stood at 7,598, off 35 percent from its peak. Unemployment was 2 percent above where it had been at the height of the boom, and GDP growth was an anemic 1.1 percent in the second quarter of 2002.

Predictions
The Dot-com bubble and its bust was foreseen by several Austrian economists. In October, 1999, Sean Corrigan pointed out a massive bubble and implied it will burst. He compared the conditions to those during the late summer of 1987, the Japanese bubble of the late 1980s, and the "roaring Twenties" in the United States. In March, 2000, Christopher Mayer noted that all the ingredients of a bubble - fundamental (i.e., a technological revolution), financial (i.e., a surge in money and credit) and psychological (i.e., a suspension of belief in traditional valuation measures) - appear to exist in the current bull market and predicted it will end with a bust. In August, 2000, William Anderson pointed to the bubble in the high-technology sector, mentioned the negative consequences of a regulatory attack at Microsoft (which was analyzed a year earlier by Thomas DiLorenzo ). There were others.

Links

 * The Crash by Albert Friedberg, June 1999
 * Irrational Exuberance? by Frank Shostak, May 2000
 * Can the Fed Control the Stock Market? by Frank Shostak, June 2000
 * Boom and Bust by Gene Callahan, August 2000
 * Fall of the Dot Coms by William L. Anderson, December 2000
 * The Dot-Com Future by Llewellyn H. Rockwell Jr., July 2001
 * What Greenspan Didn't Know by William Stepp, February 2002
 * Times Are Hard: On the Causes of the Business Cycle by Gene Callahan, April 2006
 * Dot-com bubble on Wikipedia