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ASAC 2003 Malik Datardina Halifax, Nova Scotia J. Efrim Boritz School of Accountancy University of Waterloo

BUBBLES BURST: A BRIEF REVIEW OF INVESTMENT BUBBLES THROUGHOUT HISTORY

The bursting of the Tech bubble left many wondering, “what went wrong?” The following paper looks at the Bubbles of the past dating back to South Sea Bubble of 1720 and examines the possible causes of such frenzies.

Introduction “Those who cannot remember the past are condemned to repeat it.” - George Santayana The Tech mania of the late 1990s highlighted, yet again, the ability of the economy to tolerate and promote “speculative bubbles” (henceforth, bubbles) – inflated share prices and wealth with no real substance.1 The artificiality of the wealth created during this period was clearly demonstrated by the “bursting of the bubble” and the virtual evaporation of many “Dot Com” business models as well as near collapse of stock prices in the entire technology sector. The “Dot Com” phenomenon provided a means for a variety of market players to obtain capital at the flash of a seemingly innovative, but ultimately flawed, idea. The details of this bubble are still fresh in the minds of most people, as they have felt the sting of this phenomenon in their wallets. A few highlights of the Tech mania include:

• Marketwatch.com shares were offered at $17 and closed at $97.50 (Chancellor,

1999). • In 1999, eToys had a market capitalization of $8 billion - $2 billion more than the

long-established Toys “R” Us. This was despite the fact that Toys “R” Us revenue and profit significantly exceeded those of eToys – Toys “R” Us 1998 revenue and profit were $11.2 billion and $376 million, respectively, while eToys had sales of $30 million and a net loss of $28.6 million (Shiller, 2000).

• In February of 2000, Yahoo Japan traded for over $1 million yen per share, 50 times higher than Warren Buffet’s Berkshire Hathaway shares. (Balen, 2002)

The decline of the entire technology sector in the wake of the bursting of the “Dot Com”

bubble is illustrated by the following statistics reported on the third anniversary of the Nasdaq’s March 10, 2000 peak: —————— 1 The question of what constitutes “real” substance is a complex one that is beyond the scope of this paper. For example, Steve Case, the founder of AOL attempted to convert the inflated stock of AOL into “real” substance by using it to purchase Time-Warner. Many saw this as a strategic coup, until the deflated value of AOL in turn deflated the value of AOL-Time-Warner, leading to his ouster as Chairman of the company. Similarly, using inflated stock to purchase real estate has led to the inflation of real estate prices that could lead to a sudden deflation of the value of the real estate market should interest rates rise. Even precious metals, once a haven for those seeking substance, have been shown to be vulnerable to precipitous declines in value. In this paper, real substance is viewed as value that does not deflate suddenly or very rapidly.

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• Intel – March 10, 2000 $120.19; March 7, 2003 $16.01. • Nortel Networks Corporation – March 10, 2000 $180.50; March 7, 2003 $3.20. • 724 Solutions Inc. – March 10, 2000 $304.90; March 7, 2003 $0.55. • Research In Motion Ltd – March 10, 2000 $194; March 7, 2003 $18.04. Unfortunately, the investors who suffered the consequences of these declines either were

ignorant of, or forgot, the lessons of similar bubbles that occurred in the past. And it is small comfort that even brilliant minds are not immune to being taken in by speculative bubbles – that in the South Sea Bubble of 1720, Isaac Newton himself lost 20,000 pounds (Clendaniel, 2002).

The most famous speculative bubbles of the past include: • “Tulipomania” in 1634, • The Mississippi Bubble in 1720, • The South Sea Bubble in 1720, • Great Railway Mania in 1844, and • The Radio Bubble in 1927.

According to Cassidy (2002) all speculative bubbles go through four stages: 1)

displacement, when something changes people’s expectations about the future; 2) boom, when prices rise sharply and skepticism gives way to greed; 3) euphoria, when people realize the bubble can’t last but they want to cash in on it before it bursts; and 4) bust, when prices plummet and speculators incur great losses.

The first part of the paper will discuss each of the bubbles and their apparent causes. The

second part of the paper will attempt to identify common factors that seem to permit or enable bubbles to occur. The third and final part will look to the future.

A Historical Review of Bubbles

“Tulipomania” The seeds of Tulipomania were planted when the Dutch ambassador to the Ottoman Islamic State brought tulips to Holland from the “court” of Suleiman the Magnificent in the middle of the fifteenth century. The popularity of the flower began with the upper classes, as it was initially only affordable to them (Chancellor, 1999).

Tulip collectors had classification schemes to aid in the determination of the value of the flower (Chancellor, 1999), enabling the flower to attain the status of a collector’s item similar to art (Garber, 2000). Even ten years prior to the peak of Tulipomania, the highest valued flower, the Semper Augustus, sold for the equivalent of a small house in Amsterdam (Chancellor, 1999).

Unknown to plant breeders, the cause of the spectacular patterns that were so much

admired was the mosaic virus (Garber 2000). Since, the virus was unknown to the tulip breeders, they saw the emergence of such patterns as a “lottery” of sorts – thus, any breeder could discover the “Semper Augustus” by chance and thereby attain instant wealth (Chancellor, 1999).

The tulip bulbs were traded through auctions or through direct negotiations, in “Colleges”

– rooms in inns that served the function of modern day stock and commodity exchanges (Chancellor, 1999).

The prices of tulips began to rise dramatically in 1634, largely due to the influx of outsiders (Chancellor, 1999). The tulip had become a status symbol among French women and speculators flocked to Holland to cash in on the fad (Garber, 2000). A gram of the more rare varieties of flowers had four times the value of a house, whereas., one gram of the regular

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varieties of tulips would cost approximately a quarter of a person’s annual wage. Table I illustrates the prices of tulips relative to other items (Chancellor, 1999).

The tulip bubble burst on February 3, 1637. Chancellor (1999) argues this occurred due to the fact that spring was approaching and speculators panicked, fearing that no one would purchase their tulips at any price. Ironically, the trading that was taking place between 1636 and 1637 did not involve the actual exchange of cash (Chancellor, 1999). Therefore, in hindsight, imaginary assets were exchanged for imaginary liabilities.

Table 1

Tulip Prices and other Pricing Data in 1634 Holland Panel A – Prices and wage level in 1634 Holland. Item Amount in guilders Average Annual Wage 200 to 400 Flower paintings 1,000 Small town house 300 Panel B – Prices of select tulips before and after Tulipomania 2 per gram of Tulip Tulip Variety Price before

Tulipomania (in guilders)

Price during Tulipomania (in guilders)

Gouda 100.00 1,125.00 Generalissimo 190.00 1,800.00 Croenen 0.04 60.00 Semper Augustus 200.00 600.00

Source: Chancellor (1999). Causes of Tulipomania In Famous First Bubbles, Garber (2000) argues that Tulipomania does not represent crowd madness, the traditional argument, but rather, “normal pricing behaviour.” He argues that the prices paid were a function of the scarcity of the bulbs. In addition, he argues that in 1987 “prototype lily bulbs” sold for 1,000,000 guilders ($480,000 U.S.) – demonstrating that, despite the apparently exorbitant value of the flowers, they are indeed similar to collectors’ items, rather than objects of speculation.

Shiller (2000) and Chancellor (1999) disagree with Garber’s assertion about “normal pricing behaviour” during Tulipomania. Shiller points out that Garber cannot explain why the prices of common tulip bulbs rose so dramatically. It appears that common folk drove the boom in the prices of the common flowers - drawn to speculating in tulips for their appreciative, rather than horticultural, value (Chancellor, 1999). Chancellor also questions Garber’s motives, suggesting that Garber wrote his original paper after the 1987 stock market crash to dissuade the government from regulating the stock futures market.

—————— 2 The original weights of the different varieties were not constant. The prices were adjusted to reflect the cost per gram.

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De Vries (1976) suggests the high prices of the bulbs coincided with bubonic plague which was responsible for “spreading a certain fatalism among the population that in turn kicked off the most frenzied episode of the Tulipomania. That is, people were taking higher than normal risks because they thought they would die anyway.

The South Sea Bubble & Mississippi Bubble in 1720 The South Sea and the Mississippi bubbles involved a certain amount of scheming on the part of government officials. The British government was exposed to a mountain of debt – in 1720, the National Debt stood at 50 million pounds (Garber, 2000) and the government needed to find ways to reduce the debt burden. Landowners were already overburdened with taxes (Balen, 2002); therefore, the government sought other means to reduce the debt. The government had tried other means in the past, including the South Sea Company (for details see Appendix I).

Although the South Sea Company had attracted little attention between 1714 and 1718 it was rejuvenated when King George I took it over in 1718 (Balen, 2002). King George I took a keen interest in the company due to the situation brewing in France, where John Law (a Scotsman) was running a financial experiment on a macroeconomic scale. Law was testing his idea that using paper currency instead of precious metals (i.e., the bi-metallic standard) would allow the economy to expand permanently (Carswell, 1993; Garber, 2000). The French economy, was burdened with an enormous debt load and the Regent Philip of Orleans viewed Law’s System3 as a potential cure for the country’s economic ills (Carswell 1993). The System involved the setup of the Mississippi Company that had exclusive trading rights on Canadian beaver skins as well as Louisiana. Using the Mississippi Company, Law purchased the outstanding government debt and lowered the interest rate to be paid to the government. The people, who purchased the debt, did not receive cash but instead received shares in the Mississippi Company. (Garber 2000). Using the Mississippi Company, Law purchased the outstanding government debt and lent it to the government at a reduced rate. The people who sold the debt, did not receive cash from Law, but instead received shares in the Mississippi Company. (Garber 2000). Law founded and then merged his bank with The Mississippi Company,. However, the shares of the company were flat, despite the prospects of untold treasures in Louisiana (Balen, 2002). To generate interest in the Mississippi Company’s shares, Law offered to buy the shares for par value from the investors in six months, effectively doubling their potential rewards (Balen, 2002). As he hoped, this sparked a speculative demand for the shares in the Company.4 Law enacted totalitarian measures to prevent people from converting their gains into real assets. He also printed more money to boost confidence in his currency, which resulted in the exact opposite. He then burned the money in front of the people, which only further eroded public confidence in his System. Ultimately the Mississippi Company collapsed as well as his System and he had to leave France (Balen, 2002).

The speculative mania in France fed English fears that Law’s scheme would elevate

France to the preeminent world power, as England fell behind, weighed down by its heavy debt burden (Balen, 2002). The news of the spectacular rise of the “new economy” in France made the British envious for the same (Balen, 2002) so they imitated Law’s scheme by offering shares in

—————— 3 John Law used a capital “S” to describe his System of economics. 4 The Mississippi Company issued shares with a par value of 500 livres in late 1718. The shares rose to 15,000 livres by the end of 1719. The attractive credit terms he initially offered: 15% down (i.e., of 500 livres) and then the remainder (plus interest) to be paid over 20 installments is what enabled the masses to purchase the stocks. The people believed that they could make the principal plus the profit before the loan came due.

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the South Sea Company with attractive credit terms: 20% down with eight installments paid over 16 months. As a result, the Company’s stock price jumped from its initial price of 300 pounds in April 1720 to an all time high of 1,100 pounds in June/July of 1720. The speculative furor prompted promoters to establish almost 200 other “bubble” companies to cash in on the craze. However, worried that capital would flow to these companies instead of the South Sea Company (which had taken over much of the national debt) the government passed the Bubbles Act, which cleared out most of the competition. At this point, due to easy credit the company was owed a total of 60 million pounds, compared to the initial debt level of 30 million pounds. When the government started banning the remaining competitors, investors holding shares of those companies attempted to sell, which in turn started a sell off of the South Sea Company. However, unlike the Mississippi Company which did carry on trade, the South Sea Company was really just a shell company that held government debt. Its ships were docked at the harbour and did not trade – like its future Dot Com bubble cousins, the company had no profit and no real business model (Balen, 2002).

Ultimately, the key promoter, John Blunt, ran out of cash and could not shore up the

shares any longer. Therefore, he offered a dividend of 50% to the shareholders. This merely served as a wake-up call to the speculators and they started dumping their shares, and sending the South Sea Company to its demise (Balen, 2002). Causes of the Mississippi Bubble & South Sea Bubble The Mississippi Bubble was arguably an experiment in macroeconomics, instead of a purely irrationally driven mania. The mania did depend on the masses being ignorant of finance, but the ignorance was not the driving force behind the prices of the shares. Law manufactured the hype over the shares by simultaneously offering attractive credit terms and personally purchasing the shares at a premium of 100% (Balen, 2002). Speculators saw the Mississippi shares as a road to quick capital gains.

The South Sea Bubble was driven by the rivalry between France and England. needed to find a debt reduction strategy to beat the French in the quest for world domination and feared that through Law’s “System” France would achieve dominance. In addition, the French tales of instant riches spurred on the South Sea buying spree in England. Both the South Sea and Mississippi bubbles were driven by easy credit. Law realized that he depended on the masses to drive up the price. The lure of easy credit offered the masses an opportunity to purchase shares and sell them for a quick profit before the loans came due. “Great Railway Mania” in Britain in 1845 Railway Mania had a slow start in 1825, with the first appearance of the steam railway. The industry started picking up in 1831, but faltered in 1837 due to a downturn in the economy (Chancellor, 1999). The economic downturn provided the railway industry with labour and materials at cheap prices (Lewin, 1968) 5. In addition, due to the recession, interest rates were low as well. The low interest rates made railway investments a good deal as they were paying 10% dividends, four times the prevailing interest rate (Chancellor, 1999). Railway Mania hit its peak in July 1845 when the Railway Index hit 167.9 (Gayer, 1953) as illustrated in Figure 1. However, by 1850, railway shares were worth only half the capital spent on them. In addition, the dividend rate had dropped to 2% and even nil on certain railway shares (Chancellor, 1999).

—————— 5 “Thomas the Tank Engine and Friends” is a popular children’s cartoon that was launched in 1984 (HIT, 2003). The original author, Reverend Wilbert Awdry, loved the trains and lived near the Great Western Line (Character Products Inc., 2003). The Great Western Line was built between 1836 and 1841, which coincides with the period that led up to Railway Mania (Hughs, 1999).

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The speculative spirit of the time was well documented and known throughout the

country. The Times commented on the naïveté of the speculators, as well as the fact that they were all short sighted (Chancellor, 1999).

When the capital on the shares was called (just as in the South Sea and Mississippi fiascos), the railway bubble burst (Chancellor, 1999). The government had stepped in as well to dissolve newly-formed companies that were engaged in fraudulent transactions (Lewin, 1968). Ironically, due to rapid rail transit, Britain had its first taste of “just in time” inventory – businesses could maintain smaller inventories. This resulted in a decline in economy-wide sales, as stockpiles of large inventories were no longer required (Chancellor, 1999). In addition, the downturn in share prices resulted in personal bankruptcies by those who had bet their loans on the stocks (Chancellor, 1999). To make matters even worse, the harvest failed in the summer of 1846 (Chancellor, 1999).

Figure 1

Great Railway Mania Share Index 1826 - 1850

Great Railway Mania Share Index 1826 - 1850

0

20

40

60

80

100

120

140

160

1826

1828

1830

1832

1834

1836

1838

1840

1842

1844

1846

1848

1850

Year

Inde

x

Source: Gayer (1953). Causes of the Railway Mania The Railway Mania was fed by the speculative appeal of instant riches, as evidenced by the 37,000 pounds of shareholdings held by two brothers who earned a guinea a week (Chancellor, 1999). However, it was also partially attributed to the sheer technological novelty that the railways represented The trip from London to Edinburgh took only 24 hours, whereas before it would take 42 hours by coach (Lewin, 1968). The euphoria associated with Railway Mania manifested itself in ways similar to the recent Dot Com fever. All sorts of paraphernalia associated with railways were produced. In fact, in 1845, at the height of Railway mania. one “railway” newspaper appeared per week (Chancellor, 1999).

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Radio Corporation of America (RCA) in the 1920s The Radio Boom associated with RCA is hidden behind the events that brought both prosperity and, ultimately, depression to America. One could argue that the 1920s was the greatest bubble of all time.

RCA was one of the “super stars” of the “red-hot” stock market of the 1920s (Sobel, 1986), and was known as the “General Motors of the Air” (Chancellor, 1999). The dramatic rise and fall of RCA would give any modern day investor a jolt of déjà vu, given the experience of the Tech boom.

The American government originally created RCA – a company jointly owned by

General Electric, AT&T, Westinghouse, and United Fruit – to compete in the international wireless market (Sobel, 1986). However, RCA’s visionary David Sarnoff took the company into other markets, including “radio music box” production, and broadcasting (Sobel, 1986). RCA produced the broadcasting equipment, the programming and the radio receivers for the public to listen to the programming they produced (Sobel, 1986). Sarnoff understood that quality programming was key to the long-term success of the radio industry (Sobel, 1986).

The parallels between radio and Internet are difficult to ignore as illustrated by Figure 2 which compares AOL and RCA. Radio’s principal revenue was advertising. Previously, the advertising industry was limited primarily to newspapers and had not fully developed (Sicart, 2000). However, radio radically transformed the opportunities for advertisers, as it took their messages right into listeners’ homes (Sicart, 2000). The estimated size of radio advertising was $1.8 billion in 1929 (Sicart, 2000). To put this into perspective, the American GDP in 1929 was $103.7 billion (Bureau of Economic Analysis , 2002), which meant that advertising revenues represented 1.7% of the GDP.6 RCA’s stock price rose from only $1.50 in 1921 to an unadjusted high of $572 per share in 1929 (Sobel, 1986). The price was aided by the fact that Mike Meehan, a “brokerage” operator (known as a “pool operator”) invested his funds into the stock (Chancellor, 1999). After Black Thursday (October 24 1924), the stock tumbled to $55 in 1930, and to $10 in 1931 (Sobel, 1986).

Figure 2

AOL and RCA Stock Charts

—————— 6 To put this in terms of purchasing automobiles, $1.8 billion would buy about 6,000,000 cars in 1929 (as the Model T cost about $290 in 1926). An average car today would run about $25,000US and therefore only 72,000 automobiles could be purchased with this amount of money (Schultz, 1999).

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Source: Sicart (2000) Causes of the Radio Bubble As with the Railway Boom of 1845, the technology was a tangibly new phenomenon that captured the imagination of the people. For example, for the first time people were able to experience the presidential race (Cox vs.Harding) in “real time” (Sicart, 2000). The Radio Bubble collapsed along with meltdown of the “Great Bull Market” of the 1920s. The causes of the stock market crash in 1929 are largely attributed to the increased availability of credit. At the end of the 1920s, “installment debt” was estimated to be $6 billion. More importantly 18% of the capitalization of the stock market was financed by debt (Chancellor, 1999). Like some of the other bubbles (e.g., Tulipomania, South Sea), the steep drop in prices that occurred on Black Thursday was fuelled by sheer panic (Chancellor, 1999). Many speculators blame Roger Babson, an economist from Massachusetts who cast doubt on the markets (Klingman, 1989). Babson was known to predict downward movements in the market even during the boom years of 1927 and 1928 (Thomas et al, 1979). But, despite his comparative obscurity, Babson’s prediction at the annual National Business Conference that there would be “60 to 80 point drop in the stock market” was posted on headlines across America (Thomas et al, 1979). Perhaps his message was “validated” by GM, when it announced a drop in car sales, and that “the expansion has ended” (Chancellor, 1999). These announcements were compounded by rumours that traders were going to drive the market down, by short selling (Chancellor, 1999). Ultimately, the market panicked and the result was Black Tuesday October 29, 1929. Between the Monday morning and the close of the market on Tuesday, the Dow Jones Industrial fell more than 20%, from 298, to close at 230 points (Chancellor, 1999). Tech Bubble of 1995-2000 Cassidy (2002) suggests that the launch of the Netscape IPO in August 1995 marked the start date and March 10, 2000, when the Nasdaq peaked, marked the end of the Tech Bubble, also called the Dot Com Bubble. The Dot Com Bubble refers to the rise of Internet-based business models whose e-commerce websites typically ended with the extension .com, ranging from book sales and computer sales, to pet supply sales, music sharing and on-line advertising. Graphic web browsers such as Mosaic, Netscape and Microsoft’s Internet Explorer opened up the Internet by making it easy to access documents on the World Wide Web. The U.S. government relinquished control of the Internet, turning it over to entrepreneurs who began exploring commercial uses for

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the global network. Amazon.com became a widely-touted prototype of a “new economy” business model. America On Line (AOL) was a poster child of the new economy. Ironically, Figure 2 shows the uncanny resemblance between AOL and RCA.

Paralleling the Dot Com phenomenon was the Y2K frenzy involving massive IT

spending aimed at upgrading legacy systems to prevent a massive failure of computer systems worldwide at midnight of December 31, 1999.Whether due to the effectiveness of the measures taken or due to the fact that the risks were fantastically overstated, the millennial date change occurred without serious consequence, except that shortly thereafter, the Tech bubble burst. It is interesting to note that “fatalism” was one of the factors that spurred Tulipomania (De Vries, 1976), and perhaps played a role in the mentality of the tech investors.

Figure 3

The Rise and Fall of Tech Stocks on Nasdaq

Source: Puplava (2002)

Between October 1998 and April 2000, more than 300 firms did IPOs (Cassidy, 2002) but few of those survive. During this period, the Nasdaq climbed above 5000, dropping well below 1500 after the bust (refer to Figure 3). An interesting parallel may be drawn to the 190 companies started in 1720 during the South Sea Bubble, of which only four survived (Chancellor, 1999). Causes of the Tech Bubble While some would attribute the causes of the Tech bubble to greed and dishonesty, this is not a satisfactory explanation, since these characteristics have been attributed to markets for decades. At the turn of the millennium, there was a widespread belief in the power of technology to create a “new economy.” It was believed that due to the inevitability of cost reductions stemming from the low friction, low overhead, capitalism engendered by the Internet (Gates, 1995) that in each market segment only a small number of companies would survive the “winner takes all” competition. “Internet time” was a catchphrase of the period, creating a frenzied atmosphere. Venture capitalists threw huge sums of money at fledgling startups, helping to create a gold rush mentality around Silicon Valley in California, often rushing companies to the IPO stage seeking to cash in on the phenomenon before the bubble burst (Glass, 2001).

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The Tech boom appealed to the gambling spirit of Americans of whom more than 125 million wagered money one way or another, and more than 7 million were problem gamblers. By 1999, almost half of American households owned stocks, double the 1983 figure (Cassidy, 2002). Day trading and personal investing grew to previously unseen levels; day trading accounted for about 15% of the total trading volume of the Nasdaq. By some estimates, at the peak of the bubble, up to 65% of the Nasdaq’s volume was due to online trading by individual investors (Ip et al., 2000). At the end of 2000, mutual funds contained more money than the banking system, with the bulk in stock funds. At the start of 2001 there were more mutual funds than stocks listed on the New York Stock Exchange and Nasdaq combined (Cassidy, 2002). Margin debt was used to support this level of investment activity. Many firms (e.g., telephone equipment suppliers) financed customer purchases, creating easy credit for them and disguising the risks underlying their business models while the US Federal Reserve Bank supported the expansion of individual and corporate credit through a policy of low interest rates throughout this time period (Cassidy, 2002).

The “new economy” catchphrase also suggested the need for new business models and

new valuation models. The wisdom of the day pushed companies to focus on revenue and market share rather than profit or return on investment in a quest to create a brand on the Internet. New financial performance measures such as EBITDA rather than earnings came into vogue.

Analysis of Bubbles

The risk in analyzing historical events is the temptation to fall prey to the hindsight bias; i.e., when we look back into history we feel that avoidance of Bubble mania should have been “obvious”. However, postmortem analysis of virtually any venture or invention will reveal that there were proponents and opponents of the idea. Although politicians are seldom seen as intellectually insightful, some were skeptical of Morse’s electrical telegraph (Standage, 1998). The Lumiere Brothers (who pioneered documentary silent film technology in the early twentieth century) were themselves skeptical of the potential for “moving pictures”. Debatably, U.S. Federal Reserve Chair Allan Greenspan may have been correct when he backpedaled on his own earlier comments on irrational exuberance, by stating “irrational exuberance can only be known after the fact” (Garber, 2000). Therefore, developing a “litmus test” to identify a bubble is a difficult task. This paper identifies several factors that apparently permitted or enabled the bubbles reviewed here, including novelty of a concept, official sanction, a culture of gambling, acceptance of the rationality of speculation, easy access to credit, and inadequate valuation models. Each of these “Bubble enablers” are examined in the context of each bubble in Table 2.

Table 2

Application of enabling factors to actual Bubbles

Novelty Official

Sanction Gambling Speculation Easy Credit Speculative

Valuation Models

Tulipomania P P P ? P ?

Mississippi Bubble

P P P P P P

South Sea Bubble

P P P P P P

Railway Mania

P P P P P P

Radio P P P P P P

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Bubble Tech Bubble

P P P P P P

Novelty of the Prospect

With all inventions there is a chance that life will change dramatically. The rate of change is determined by many factors. However, during the initial on-set of the technology, the public has a euphoric sense that the “sky is the limit”. As a result, the investment in technology is fuelled by this sense “traveling into the unknown”. The ability of crowds to sense the technology spurs them on to invest into the bubble, and to accept the truth of the most grandiose claims. The mosaic virus produced extraordinary patterns that were uncommon (Garber, 2000). The Mississippi and South Sea Bubbles saw the advent of fiat currency and the creation of numerous stock companies. The railways dramatically reduced travel time between towns, e.g. trip from London to Edinburgh took only 24 hours, whereas before it would take 42 hours by coach (Lewin, 1968). Radio broadcasts connected people over vast geographic distances to share a single event while the Internet and e-commerce enabled “interactive in-house shopping.” Official Sanction Bubbles require some feature that distinguishes them from a Ponzi scheme7 or another type of fraud. The public requires officials or respected individuals to “bless” the venture and consider it valid. Tulipomania was endorsed by the nobility who coveted tulips (Garber, 2000). The French regent, the Duke of Orleans, expressed his confidence in John Law’s System, while King George I invested 100,000 pounds in the South Sea Company. Queen Victoria took a ride on the railways in 1842 and the laissez-faire position held by the government blocked legislation that would have ended speculation in railway stocks (Chancellor, 1999). The US government was instrumental in establishing RCA as the leading radio company (Sobel, 1986) while Alan Greenspan’s acceptance of what he had himself called “irrational exuberance” gave official sanction to the Tech mania (Cassidy, 2002). Culture of gambling The ability of people to be pulled into a venture is associated with their inclination to engage in games of chance. The popularity of gambling in a culture indicates the level of “risk aversion” a society has. Therefore, the more popular it is to gamble, and the less risk-averse the society is, the more willing its members are to take risks in business ventures. Planting tulips had a gambling appeal as there was a chance to get the coveted Semper Augustus and “win a fortune” (Chancellor, 1999). Law made his fortune by gambling (Shiller, 2000). In 18th century England, gambling was commonplace and the government exploited this feature with the Tontine Loans and Lottery Loans (See Appendix I) while in the 19th century Lord Ashton commented on the “feverish state of gambling events connected with railways” and The Economist noted the absurdity of the valuations by citing the fact that all ten railway proposals sold for a premium, when it was clear that only one proposal would win (Chancellor, 1999). The 1920s coincided with a “gambling craze” in the U.S. brought on by the growth in organized crime to supply the nation’s illegal consumption of alcohol. Most recently, between 1975 and 1999,

—————— 7 Ponzi schemes are purely fraudulent “investment opportunities” where the initial investors are paid dividends by the capital received from the second round of investors. The chain goes on and on until there are no more investors and then the last group is left with nothing (Garber, 2000).

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U.S. state lotteries increased from 13 to 37, and between 1990 and 1999 casinos increased from 2 to 360, which resulted in 125 million Americans having gambled in 1998 (Cassidy, 2002). Speculation is rational Speculation is distinguished from gambling by the fact that gambling is built on pure chance, while speculation is supposed to be an exercise of entrepreneurial skill (Gabaldon, 2001). In most microeconomic textbooks, the rational individual is described as a person who would prefer to earn more than less, and have more leisure time than less. Therefore, it is rational for individuals to want to get large sums of money for minimal effort and it would appear that speculative behaviour is intrinsically part of such a mindset. Although the tulip craze appears to have been predominantly a gambling enterprise, a case could be made that some speculators saw themselves in the collection business as some bulbs were considered “collector’s items.” Law believed that the economy would be stimulated by an injection of (fiat) currency and the Mississippi Company had actual trading potential (Garber, 2000). This distinguishes the Mississippi Bubble from the South Sea Bubble which does not appear to have had a rational economic premise to support it. However, the bubble company phenomenon spawned by the South Sea Company resulted in companies that survived the bursting of the bubble (Chancellor, 1999). Therefore, it could be argued that a diversified portfolio amongst the bubble companies would be a bona fide speculative enterprise, as there were legitimate business models underlying at least some of these companies. The ability to speculate affords opportunities to jump from the working or lower class to the wealthy upper class in order to achieve the “American Dream” or its equivalent. During the South Sea bubble, the “nouveaux riches” wanted to ensure that their wealth from the stocks translated to “permanent status” by way of land ownership (Balen, 2002). During Railway mania, George Hudson, the “Railway King”, was hailed as a hero who rose from a linen draper to a “living symbol of the get-rich-quick mentality” (Chancellor, 1999). Therefore, these speculative episodes created a public opinion that migration between classes is possible. Although Bubbles feed people’s hopes and beliefs that they can achieve status through speculation, this may not be borne out by actual experience. Philips (2002) argues that the wealth accrued from the stock market run-up between 1989 and 1997 was retained by the top 10%. Cassidy (2002) reports that in 1983 1% of American households owned 90% of all stocks and 75% of households owned no stocks at all. By 1998, almost 50% of households owned stocks but the top 1% still owned 80% of all stocks. This suggests that most of the speculative profits and losses from the Tech bubble would have primarily affected a small proportion of American households. Easy money – freely available credit The ability to participate in any investment opportunity requires capital. Therefore, for the masses to be able to participate in any “mass investment opportunity”, they need access to “cheap capital”. Easy credit works in tandem with speculative behaviour. Investors think that they can get out with quick profit before the price goes down and before the creditors call. Tulips were exchanged for promissory notes (Chancellor, 1999) rather than cash. Attractive credit terms were offered to attract the crowds to invest in the Mississippi and South Sea ventures. Exchange banks provided loans up to 80% of the value of railway shares (Chancellor, 1999 – p. 134, referenced to Tooke) In 1929 nearly a fifth of the Bull market of 1929 was propped up by credit (Chancellor, 1999) while margin debt on the NYSE and Nasdaq increased 64% from April 1999 to April 2000 to a record high of $242 billion (Cullen, 2000). Bubbles are also permitted by the inherently speculative valuation models

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Tulips were traded on the basis of promissory notes, enabling paper liabilities to offset paper assets. The South Sea Company did no trading. Instead, it instigated “bubble” companies that were fraudulent (Chancellor, 1999). It is interesting that the idea of discounting cash flows (DCF) as a valuation model emerged in the 1920s (Chancellor, 1999). At that time, stocks were thought to be solely speculative (Chancellor, 1999). The DCF model requires investors to estimate or guess the numerator and denominator of the equation (i.e., the cash flows as well as the discount rate). As such information can only be known with certainty in the future, it is impossible to independently verify such information in the present. The theory of discounted cash flows permits companies to promise investors capital appreciation of their stocks based on projected future cash flows that may never materialize, as the companies may go bankrupt long before they can generate positive net cash flows.

Lev (2001) reported that more than 80% of companies’ market value was represented by intangible assets. Although intangible assets (e.g., goodwill) have been the subject of valuation debates for decades, the advent of the Dot Com companies of the 1990s required a fresh look at the subject. Draper (1999) strongly denounced any attempt at measuring intellectual capital of start up companies. He argued that it is impossible to independently verify such a value, and that it is anyone’s guess. However, if this is true there is no way to verify the reasonableness of stock prices, except by placing one’s faith in market efficiency.

Bubbling Ahead One would think that given the recent experience, we would be sensitized to the risks of bubbles. However, there may be yet another, very dangerous bubble in the making with little attention being focused on it. This bubble may be a reflection of global speculative activity that is visible only to a small group of traders who operate in this sphere of the global economy. Consider that in May 1996 $1.25 trillion worth of transactions were traded per day (Henwood, 1997). To put this in perspective, the U.S. annual GDP is only 7 times this number; the world annual GDP is only 30 times this number (Henwood, 1997). In 1971, 90% of the transactions were associated with the real economy, but in the early 1990’s, only 10% of the transactions were associated with the real economy (Eatwell, 1993). The rest is speculative activity (Eatwell, 1993). Is this the next bubble in the making? The sheer size of global speculative activity is a cause for concern, as the past experience with bubbles is that they must burst sometime, leaving significant consequences in their wake.

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Appendix

British Debt schemes in the 17th century

The schemes introduced by the government tried to appeal to the people’s inclination to gambling. This included the Tontine Loan and the Lottery Loans: The “Tontine Loan” or tontine (in 1693). As with a regular loan, the tontine paid out interest to the debt holder (Reading, 1978). However, as each subscriber died, the holder would forfeit the loan, and the interest that accrued to him or her, would be redistributed to the remaining debt holders (Merriam-Webster, 1997). The Lottery Loans (in 1694). The attractive aspect of this “lottery” was there was no downside. The gambler would purchase the ticket for 10 pounds, and then be guaranteed a return of 1 pound per year (Balen, 2002). In addition, the lottery offered 1 “grand prize” of 1,000 pounds per year, 9 prizes of 500 pounds per year, 20 prizes of 100 pounds per year, and 2,000 prizes of 10 pounds per year (Balen, 2002).

“Joint stock companies” (in 1711). The government used “joint stock companies” as means to pawn off its debt to the public (Reading, 1933). John Blunt who earned his notoriety with the government through the financial dealings of the Sword Blade Company (which later on became Sword Blade Bank), worked with Robert Harley, the Chancellor of the Exchequer, to make Great Britain’s debt disappear (Carswell, 1993). The plan was that the South Sea trading company would take over 9,000,000 pounds worth of debt and obtain exclusive trading rights to present day South America8 (Reading, 1978). The Company could not force the government debt holders into giving Blunt their debt holding so the Company offered them a premium for their debt instruments (Chancellor, 1999). In the Devil takes the Hindmost, Chancellor notes that companies were permitted to make profits by selling shares above their par value. Therefore, if the company had a total par value of 1,000,000 pounds, any excess over that gained by appreciation in the share price was considered a profit that could be distributed to the company’s initial shareholders. Therefore, the goal was to sell the shares for the highest price possible, in order to reap the highest profits (Chancellor, 1999). The South Sea shares had a par value of 100 pounds, and the company was authorized to issue 315,000 shares (Chancellor, 1999). The market had a great deal of trouble deciphering what the real value of the offering was. According to the pamphleteers9, the South Sea Company was slated to capture the lion’s share of trade from the Peace Treaty between England and France. (Between 1701 and 1714, England and France were at war with each other. The war was known as “War of Spanish Succession”, Levick 1999). However, in order to trade in the South Seas (that belonged to Spain) there would need to be peace between Spain and Britain, which came with the signing of the Peace Treaty of Utrecht (Reading, 1978). However, this treaty did not provide the boon the Company expected (Reading, 1978). They were able to trade slaves, but the Spanish wanted a quarter of the profit, as did Queen Anne (Balen, 2002, Reading, 1978), leaving an insignificant amount for the company. —————— 8 The Bill (passed on September 8th, 1711) that included the South Sea’s charter described the area as “the area comprised being on the East Coast from the River Aranoca to the Southernmost part of Terra del Fuego and on the West Coast from the said Terra del Fuego through the South Seas to the Northernmost part of America.” 9 Daniel Defoe and Johnathan Swift published pamphlets of exports and wealth potential in South America.

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