Staying calm.

Photographer: Phil Walter/Getty Images

Don't Panic -- It's Only a Tech Bust

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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The tech bust, which everyone thought was coming, is probably here. Venture capital funding is receding, companies are raising money at reduced valuations, and the rate of creation of “unicorn” companies (venture capital-funded private companies valued at over $1 billion) has slowed. Here is a chart, via Bloomberg View’s Jim Greiff:

No one knows how far the bust will go, how many unicorns will go out of business, or to what degree private-market funding will dry up. In the early stages of a bust, it’s very hard to tell how bad things will get. When housing prices began falling in 2007, for example, the initial reaction was only vague unease. In fact, the bust might prove to be only a temporary blip -- Fidelity, which made headlines in November by slashing its estimates for the value of many top startups, recently marked up the value of many.

With that caveat, though, the interesting thing is how little dismay and panic the bust is generating. Even the possibility of a longer or more severe downturn in the tech startup world is not causing the kind of national consternation that the bursting of the tech bubble caused in 2000. The financial world also seems calm.

Why? I think there are several reasons, and they all point to one conclusion: This time, the U.S. financial system is working the way it’s supposed to work.

First of all, what’s happening in tech really isn’t a bubble, though it often gets called that. A true bubble doesn’t just mean that people accidentally pay more for assets than they’re worth; it means that the market is going haywire. Some theories say that bubbles involve speculation -- investors buying at prices that they know are above long-term fundamental values, in the expectation that they can find a “greater fool” to buy the assets at even higher valuations. Other theories say that bubbles are marked by herd behavior: Investors see others buying and join in with the expectation that the people they’re copying know what they’re doing.

But in the current case of the tech bubble, neither herd behavior nor speculation could have gotten very far, because most of the action was confined to the private markets. It’s hard to speculate in private markets, since there aren’t many opportunities for resale of stock. And herd behavior is difficult, because there are a far smaller number of players in the market, and each company’s stock has fewer buyers than in the public markets.

Yes, a little of each of these phenomena might have been present in the recent tech boom -- “fear of missing out” can act like herd behavior, and a few early-stage investors resold their stock. But the illiquidity of private markets essentially prevented either of these things from happening at a large scale, so markets couldn’t stray too far from rationality.

So, because this tech boom was never a true bubble, the bust is unlikely to be as severe as in 2000.

A second reason the world doesn’t seem to be panicking over tech is that the average investor is just not that exposed to the sector this time around. The eye-popping valuations of companies like Uber are only notional. The number of dollars actually invested is far smaller. Even the largest venture capital funds are tiny -- Sequoia Capital, for example, manages only about $10 billion in total, about 1/7 the size of the largest hedge funds and 1/25 the size of the largest actively managed mutual funds. Large investors like pension funds and mutual funds allocate only small percentages of their assets to tech startups.

That means that unlike in 2000, a bust in the tech sector won’t cause many normal people’s wealth to evaporate, leading them to cut back drastically on consumer spending. Nor is the financial system especially exposed this time. Even if the tech bust becomes truly catastrophic, few people will lose their life’s savings, banks won’t fail, and the economy won’t crash.

In other words,  the U.S. financial system is doing what it’s supposed to do -- funding productive investment while managing risk effectively. Instead of disguising risky investments as safe assets, as was done in the housing bubble, the financial industry has kept tech startup investments confined and limited. When times were good, funding expanded enough to allow tech entrepreneurs to do big things like make self-landing rockets and revolutionize the taxi industry. Now that the sector is cooling off, capital is pulling back, but not in a disastrous rout.

Some founders and early employees -- it remains to be seen how many -- will lose money, but they knew what they were getting into when they signed on. Equity is risky, private equity is riskier, and private equity in high-tech growth industries is the riskiest of all. This time, unlike in the big bubbles of the 1990s and 2000s, the risk will be borne by the people who chose to take it.

Whether our finance industry has learned its lesson, or whether the post-2008 era is simply a short period of unusual caution, remains to be seen. But for now, the system is working like it should. As for the tech founders and engineers, they'll be back. Technology is a cyclical industry, and demand for smart and enterprising people making interesting new stuff is unlikely to dry up for long.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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