FOOL ON THE HILL
It's Our Fault

According to writer John Cassidy, our own greed and gullibility was the real story of the Internet "bubble." Painful as it is, he's right. Financial education is the only antidote.

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By Tom Jacobs (TMF Tom9)
August 8, 2002

I recently finished reading Dot.Con, by The New Yorker's superb economics writer John Cassidy. The book would've been more than satisfying with his riveting, carefully researched, goes-down-easy history of the dot-com era alone. But he had larger ambitions: "[T]he Internet boom and bust was about America -- how it works and what it thought of itself in that short interregnum between the end of the Cold War and September 2001. America is the underlying subject of this book," he writes.

He wants us to see not only the movie but the world outside, ending around 9/11 and before the corporate number imbroglios. It's easy to be distracted by Enron, Tyco, WorldCom, and Adelphia, but they're not dot-coms. Without the executive and auditor machinations, we still had a market explosion around the Internet. And in fast-reading 325 pages, Cassidy tells us why.

The dry tinder
After a fascinating 16-page history of the Internet, Cassidy makes the case that four factors set the stage for the Internet stock market boom. First, the Cold War ended with America's brand of capitalism acknowledged worldwide as the winner and premier economic model. Second, "the Internet represented a new paradigm for human development," one philosophers and futurists augured with talk of a global village and the disappearance of borders. With fewer threats to national security, the population was more easily seduced by apocalyptic dreams of an "information superhighway" and its liberating possibilities.

Third, not only IRAs but 401(k) plans were born, bringing millions of people to stocks for the first time. In the late 1990s, $170 billion a year gushed into stock mutual funds, or $130,000 per household. In 1983, 1% of American households owned 90% of all stocks, but by 1998, that had dropped to 80%, and 50% of households counted stocks among their assets. Finally, baby boomers -- those, like me, born from 1946 to 1964 -- entered their peak earning years and selectively absorbed the lessons of books such as Jeremy Siegel's Stocks for the Long Run, which explains that stocks over the long term (at least 20 years) provide better returns than other asset classes such as bonds or real estate.

In sum, lots of us were sitting pretty with cash, all dressed up... but where to go? We believed (correctly) that the stock market was the best place to put it, though we may have ignored the caveats. And we may have needed -- and still need -- someone to help.

Cast of characters
All your old favorites get airtime. Marc Andreesen invents the Internet browser, and Cassidy argues that Netscape's 1995 IPO starts the stock boom. In 1996, Mary Meeker and Chris DePuy circulate The Internet Report -- quickly picked up by publisher HarperCollins -- that purported to give investors a way to grasp the business models and understand where companies stood on the Internet landscape. The Internet business world becomes four-layered: telecom equipment makers, browser companies, access providers (ISPs), and content providers such as Yahoo! Financial media abet the interest, with CNBC, Wired Magazine, and James Cramer singled out for particular influence.

While the media responds with supply to the demand for Internet content, investment bankers facilitate the IPOs to meet investor demand for supply of Internet shares. Cassidy focuses intently on some of the leading winners of all sides of the IPO game. Jeff Bezos leads Amazon while it loses more and more money, yet its stock rises higher and higher. Meeker releases her online retailing report, and venture capitalists fund startups to sell anything via the Internet. For a time, even individual investors profit from the wild upward stock moves.

The undertaker
The single individual to which Cassidy devotes the most ink is Federal Reserve Chairman Alan Greenspan, nicknamed "the undertaker" in his days in Ayn Rand's circle. Greenspan may have intoned "irrational exuberance" in 1996, but, in Cassidy's view, the central banker gave a green light to the boom, when in the latter half of 1998 the Fed began a series of rate cuts before the economy got in trouble. Its goal was apparently to calm financial market jitters when hedge fund Long Term Capital Management faced its cash crunch. The Fed hadn't shifted rates since March 1997, and not by more than 0.25% for three years. To Cassidy, the Fed chairman had not only told the partygoers to stay as long as they wanted, but gave them chits for unlimited food and drink and told them the police were on vacation. The Fed dumped fuel on the fire.

At the same time that Greenspan cut rates and touted the economy's amazing productivity growth (growth was revised significantly downward last August by the Bureau of Labor Statistics), economists of equal or greater stature -- Nobel Laureates Milton Friedman and Paul Samuelson -- said openly that the bubble was greater than in 1929. Samuelson said Greenspan "had painted himself into a corner. He's now dealing with the physics of avalanches." Someday Greenspan would have to raise rates, and no one doubted the effect.

The end 
Cassidy identifies three warning signs that the boom was reaching its height. First, predictions that everything would only accelerate: the Dow 36,000 prediction of James K. Glassman and Kevin Hassett and the passionate prognostications of futurists Harry Dent and George Gilder. (Aside: The best thing I ever read about Gilder was that a friend took everything he said and added five years.) Second, the lionization of Internet company heroes such as Jeff Bezos, a cult-like figure in his own company and a TIME magazine cover boy, who led a company he believed needed to lose more money to achieve its business ambitions.

But the loudest and brightest warning, according to Cassidy, was third: America Online's purchase of Time Warner, announced in January 2000. While many announced the death of traditional media, Cassidy points out the irony that Steve Case obviously didn't agree, and concludes, "Case had torpedoed his company's stock, but he had ensured its long-term future." Two years later, the former is more clear, and the latter uncertain and fervently debated.     

With that, and the Fed's series of rate increases beginning in January 2000, it all began to unravel. 

Why?
Cassidy is willing to accept some of the blame:

The fundamental lesson of a speculative bubble is that behavior that seems rational at the individual level can lead to collective insanity. Trapped in the logic of herd behavior, Wall Street will inevitably keep inflating the bubble until it bursts. It is up to journalists and government officials to try and maintain sanity, but in this case neither proved up to the task.

I might believe the former -- and at the Fool, we certainly tempered enthusiasm with warnings -- but the government? Sure, the SEC has some powers, but what does Cassidy have in mind?

Not Greenspan, apparently, because, "As a fervent disciple of the free market, Greenspan believed that people's investment decisions were largely a matter for them, even if they didn't make sense." Exactly. Turn-on-a-dime reallocations of capital in a free capitalist economy might cause whiplash and worse. People are hurt, and no one can deny the enormous pain. (I've felt it, too.)

Yet isn't this preferable to government allocation of capital? Billions of dollars moved to businesses related to the Internet, and it was not all productive. Japan's centrally directed post-World War II boom led to its current mess. We may face an economic winter, but what would you do instead? 

We're addressing executive misconduct and juggled numbers, but we're still left with economic forces we can't change without great peril. Do we want to decide where venture capitalists can put their money? To limit them in getting a return on their investment through IPOs? Do we want to limit risk -- and therefore returns -- for investors in stocks? And if so, who's going to make these decisions, and isn't that medicine worse than the disease -- even if the disease turns to a depression?

If you answer "no," that leaves only the mirror. Cassidy concludes, "Silicon Valley, Wall Street, the media, and the Fed all played roles in the Internet bubble, but when all is said and done, it was primarily a story of greed and gullibility on the part of the American public."  

The only response to that is financial education, which this country strongly lacks. We need it so investors, who may be as scared away from stocks as they were after 1929, save and invest smartly, with enough knowledge to exercise that most ancient caution, caveat emptor. And that education, folks, is the Fool's reason for being.

Dot.Con is an engrossing history that reads like a novel; the only criticism is that it lacks an index. Give it a read, and then please join me and other Fool Community members to discuss it, and any other money book, on our Investing Books discussion board.

Tom Jacobs (TMF Tom9) is going kayaking. See ya later. At press time, he owned shares of no companies in this column. To see his stock holdings (what for?), view his profile, and check out The Motley Fool's disclosure policy.