In Case of Tech Bubble, Do Not Break GlassChris Farrell
In Silicon Valley, it's beginning to feel like déjà vu all over again. Much as in the early-to-mid-90s, a euphoria is surrounding new consumer technologies. Then, it was early Internet software, such as Netscape, and such dot-com darlings as eBay (EBAY) and Yahoo! (YHOO). Now the excitement involves mobile devices such as Apple's iPhone and iPad and social network services such as Facebook.
Tech valuations are once again soaring: Apple (AAPL) recently became the second most valuable company in the world, behind ExxonMobil (XOM), with a market cap of $305 billion. Even more striking is the $50 billion valuation that private investors have placed on Facebook. Groupon, a cyber-coupon company, turned down a $6 billion takeover offer from Google (GOOG) last month, and it's now considering an IPO that could reach $15 billion. "We may be on the cusp of another technology-driven boom," says Erik Brynjolfsson, director of the MIT Center for Digital Business.
Or another tech bubble. The last one ended badly—for stockholders, when the tech-heavy Nasdaq index fell from more than 5000 in March 2000 to 1100 in late 2002, and for everyone else in the recession that followed. Now, as investors grow giddy again, odds are the Federal Reserve Board will confront far sooner than expected one of the most difficult and divisive issues in central banking: Should it attempt to deflate an asset price bubble before it grows large enough to threaten the financial system and economy when it pops?
Blunt Instruments in Abeyance
The answer, in a nutshell, is no. But that isn't the same as saying the Fed should do nothing. Quite the contrary. Much as it's hard to watch a slow-motion traffic accident play out—especially if you're still stumbling away from another totaled vehicle, as we are with the housing crash—it's far better for the Fed actively to prepare institutions for the fallout of another bursting bubble than to try to head one off with its limited array of blunt instruments. The call to action is targeted, but bold, regulatory initiative.
Of course, speculating about a bubble is, well, highly speculative at a time when inflation is dormant and the unemployment rate is 9.4 percent. Nevertheless, the parallels between now and the mid-'90s are striking. For instance, the milestone marking the dawn of the Internet era was the August 1995 initial public offering of Netscape at $28 a share, closing at $58. It captured consumer imagination and woke companies up to the Web's commercial possibilities. The dot.com boom began, with entrepreneurs from Silicon Valley to Route 128 forming startups at an astonishing pace. Established companies raced to invest in e-commerce, construct their own websites, and overhaul their organization to take advantage of the Internet. Think Amazon.com (AMZN), Google, and Monster.com as well as Cisco Systems (CSCO), Microsoft (MSFT), and Intel (INTC).
Today's surge in technology investment also goes deeper than the latest Web raves. Private sector investment in equipment and software was up 15.4 percent in the third quarter of 2010 vs. a 4.2 percent gain in the same period of 2009 (and an 11.1 percent decline in the third quarter of 2008). Investors are thrilled. The one-month return on the Information and Technology sector is 4.61 percent, while the Standard & Poor's 500 index came in at 2.96. The numbers for the past three months are 12.1 percent and 8 percent, respectively.
It's intriguing to note another echo. When Netscape went public, according to calculations by economists John Campbell at Harvard and Robert Shiller at Yale, a cyclically adjusted price/earnings ratio, which takes into account earnings going back a decade, of the S&P 500 stood at 23.2 times. Yet by December of the following year, the ratio had climbed to 29 times—a nosebleed figure that persuaded then Fed Chairman Alan Greenspan to give his "irrational exuberance" speech at the American Enterprise Institute in December 1996. The current Campbell/Shiller p-e ratio is 23.2, up from a recent low of 19.7 in June 2010. It's on the upswing. "With the mobile-tech boom scenario, core inflation might stay low and unemployment might stay high, because it would elongate the productivity gains," muses James W. Paulsen, chief investment strategist at $354 billion Wells Capital Management in San Francisco.
Indeed, inflation was tame and productivity strong during both the dot.com boom and the real estate bubble. And the Fed—America's guardian against a debased currency—felt little pressure to make major shifts in monetary policy with inflation quiescent. Yet the toll when the bubbles burst was huge. During the Great Recession, 8.4 million workers were dropped from payrolls, household wealth plunged more than $11 trillion, and, over a 24-month period ended in June 2009, more than 167,000 businesses failed, according to Dun & Bradstreet. The accumulated human and economic price tag of allowing bubbles to run their course has convinced Mark Thoma, economist at the University of Oregon, that "there is a role for the Fed to pop bubbles."
Problem is, it's a tricky business figuring out whether an asset is over- or undervalued. For instance, when Shiller persuaded Greenspan that the stock market was overvalued, priced at about three times the underlying fundamentals, Shiller also expected that over the next decade the return on stocks would be zero. Yet the stock market did slightly better than its historic average of a real 6 percent return by the end of 2006. (Of course, timing matters; Shiller was right for the 2000s as a whole.) Thoma favors a more activist Fed, but he worries it doesn't have good enough statistical measures to know when to lean against a boom and when to let the excitement rip. "It's hard to judge the costs vs. the benefits," he says.
Positive Side of Speculation
Among those benefits are entrepreneurial risk-taking and the animal spirits of innovation. "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the [1890s], would have been on balance beneficial to the populations concerned," wrote the British economist Dennis Robertson in 1926. Arthur Rolnick, former head of research at the Federal Reserve Bank of Minneapolis and currently senior fellow at the Humphrey Institute of Public Affairs, agrees with the Robertsonian point of view: "Sure, there's speculation, but this is how we want markets to work," Rolnick says. "It's the way we innovate and bring new products to market."
Not all innovations are desirable, of course, as we've seen recently. Much of the whiz-bang financial technology that made the housing bubble possible turned out to be toxic. Still, even if economists can agree on a set of statistical guideposts for determining the madness of crowds, monetary policy is often too blunt a policy instrument. Sure, the Fed can always pop a bubble by sharply hiking the fed funds rate. But that will also stymie angel investors, venture capitalists, and other intrepid investors from funding profitable ideas bubbling up from university labs and corporate research departments.
"The Fed raising the fed funds rate to deal with a bubble in one sector of the economy isn't very smart," says David Laidler, economist at the University of Western Ontario. "Whether the problem is in high tech or in housing, you're using an economy-wide instrument to deal with it, which isn't wise."
The Canadian Model
The solution, many economists agree, is for the Fed to place a far greater emphasis on regulatory initiative than monetary policy when confronting bubbles.
Take the new mortgage rules announced by Canadian finance minister Jim Flaherty on Jan. 17. For the second time in less a year, the Canadian government acted to lean against ballooning consumer debt in a low interest rate environment to "protect the stability of the economy." In sharp contrast, when the stock market entered nosebleed territory in the late 1990s, the Fed ignored calls to raise margin requirements in the stock market, a targeted regulatory move.
During the real estate bubble, federal regulators had plenty of tools at their disposable to cut short the widespread abuses. Edward Gramlich, the late Federal Reserve governor, repeatedly warned about abuses in the subprime mortgage market and urged that the Greenspan Fed unleash investigators on lenders trolling for customers in poor neighborhoods and examine in detail their relations with major financial institutions. The Greenspan Fed, enamored with the elixir of deregulation, ignored his advice. "Regulators didn't do their job," says Rolnick.
Indeed, the Securities & Exchange Commission should step up its scrutiny of private investors and company valuations in the growing trading market for private share offerings of such marquee high-tech companies as Facebook, Twitter, and LinkedIn. Even more important, the Fed needs to exercise the extra oversight powers it got in the Frank-Dodd financial services reform legislation last July. (And Congress should avoid watering down the rules and regulations.)
Here's the thing: Plenty of mobile Internet companies, social networking firms, and other information technology companies will get funded over the next few years. Many of them will fail. That's capitalism. Regulators need to concentrate on preventing major financial institutions from feeding the frenzy and putting the taxpayer at risk. That's regulatory prudence. Stay tuned.