Greg Ip

Articles by The Economist’s U.S. Economics Editor

Silver Lining: Amid Devastation, Many Still See Gains In Burst Tech Bubble

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Even Sufferers Cite the Value Of Innovation and Base For Longer-Term Growth — Looking Again to the Fed

By Greg Ip

Staff Reporter of The Wall Street Journal

2497 words

20 March 2001

The Wall Street Journal

A1

English

(Copyright (c) 2001, Dow Jones & Company, Inc.)

WASHINGTON — As the U.S. economy struggles with the bursting of the high-tech bubble, here’s an improbable question: Could there also have been a bright side?

Billions of dollars went down the drain in the past few years, to support high-tech companies that never made a profit. Years of entrepreneurial effort by the nation’s best and brightest were flushed away on failed business plans. Massive wealth was created, and then destroyed, leaving shattered confidence in its wake.

Yet the bubble also may have done society a huge favor. The technology-stock boom fertilized new technologies and business innovations, and it galvanized old-economy companies into accelerating their own adoption of these innovations.

“The introduction of the Internet and wiring of the economy with new forms of communication happened much more quickly than it would have in the absence of the stock-market boom,” says David Hale, global chief economist for Zurich Group. “There’s no doubt we threw too much money at the sectors that were popular. But the fact is there was a far-reaching change in technology that will affect how we do business for many years to come.”

Assessing the impact of the bubble is of crucial importance as Federal Reserve Board Chairman Alan Greenspan and his colleagues meet today amid mounting signs of economic distress. Financial markets are expecting the central bank to cut its target for the key “federal funds” interest rate by either half or three-quarters of a percentage point.

The central bank contributed to the high-tech boom by keeping interest rates low through most of the late 1990s. Then it helped prick that bubble by raising rates last year.

Over the long term, Fed economists — as well as most private and government forecasters — are still hoping and expecting the turbocharged technology investment of recent years will help power a decade of unusually strong growth. They are predicting average growth rates in the coming decade will be significantly higher than in the 1970s, ’80s or early ’90s. That strong expected growth, in turn, provides the basis for government predictions of large budget surpluses. If all that is borne out, the high-tech bubble will have done more good than harm.

Technological advance almost seems to require periodic investment manias. The bull market of the 1920s, for example, enabled many companies to exploit the emerging technologies of electricity and the internal-combustion engine, whose benefits survived the 1929 crash and Great Depression, says Boyan Jovanovic, a co-author of a study on the subject and professor of economics at the University of Chicago.

Historically, says Mr. Jovanovic, the problem with markets isn’t too much risk-taking, but too little. That’s because all of society reaps the benefits of an invention, while the innovator bears the costs. Stock-market bubbles help overcome that market failure by tempting innovators with enormous wealth. “We’re never worse off for having generated more ideas,” he says.

Mr. Greenspan seemed to recognize that fact when he testified to Congress in January 1999. “With all of its hype and craziness, it’s something that, at the end of the day, probably is more plus than minus,” he said of soaring Internet stocks at the time.

Even though many dot-coms have proved to be dubious businesses, their existence prompted mainstream companies to speed the development of technologies now finding broader use. In 1999, EMC Corp., a big maker of data-storage systems in Hopkinton, Mass., began hearing from surging new dot-com companies, some of which were demanding as much storage as big money-center banks had needed over 10 years. Determined not to lose the opportunity, EMC’s sales force established special “dot-com districts” to cultivate this new breed of customers. Soon, it was selling to the likes of eToys Inc.

In their quest to expand, this new breed of company pestered EMC for the ability to copy — or “mirror,” in industry jargon — huge databases between remote locations so that customers wouldn’t encounter bottlenecks trying to view the same information on one computer server. EMC technology already made that possible, but only over expensive high-speed telephone lines used mostly by big companies backing up mission-critical data. To produce a cheaper solution for dot-coms, Jim Rothnie, EMC’s chief technology officer, says a team of engineers went to work figuring out how to mirror data over less-costly Internet data lines.

The product was ready by early 2000. And EMC’s 1999 annual report features eToys‘ then-chief information officer, John Hnanicek, gushing, “EMC plays a huge role in ensuring that our customers receive prompt response time, and that our company can accommodate . . . dramatic business growth.”

Despite its interest in the new mirroring product, eToys never got around to buying it. A year later, it has filed for bankruptcy protection, and the loss of numerous dot-com customers like it has hit EMC’s sales and stock price. Yet EMC’s Internet-based mirroring technology, like many products originally designed for the dot-coms, has proved popular with old-economy companies. One big container-shipping line has used it to move its database from the U.S. to Britain.

“A lot of infrastructure gets created in the shadow of the bubble which ultimately is useful for many purposes,” says Mr. Rothnie. “It is true in our product line.”

One measure of innovation, the number of patent applications by U.S. inventors, soared along with the Nasdaq, from an annual average of 70,000 between 1978 and 1992 to 135,000 in 1998. A study of manufacturing innovation by Samuel Kortum of Boston University and Josh Lerner of Harvard Business School attributes a chunk of that increase to rising venture-capital investing, which they conclude generates more innovation per dollar than corporate research-and-development departments. Between 1978 and 1992, they found, firms backed by venture capital conducted 3% of R&D but accounted for 8% of patent applications. By 1998, they accounted for 5% of R&D and 14% of patent applications.

Judging by the return to investors, much of the money spent during the bubble didn’t generate genuinely useful ideas, and that’s one of the reasons the downside is so deep. More than 700 technology companies have gone public since 1998, according to Thomson Financial Securities Data. Three-quarters of them, when they last traded, were below their offering price. Lenders and shareholders could ultimately lose even more on telecommunications companies that have spent lavishly laying fiber-optic networks, buying “third generation” cell-phone licenses or trying to compete with the Baby Bells in local phone service.

“There are 16 different fiber-optic networks spanning North America, and I’ve had some people count as many as 21,” says Paul Sagawa, telecom-equipment analyst at Sanford C. Bernstein & Co., and “all do the same thing.” He estimates that since 1998, these companies have consumed about $100 billion in cash, “never to be seen again.”

The builders of this broad-band capacity argued that it would be rapidly absorbed by exploding Internet traffic. But Mr. Sagawa says the revenue earned doing that is nowhere near enough to justify the investment: excess capacity is driving prices down 75% a year. “What we have is the backbone and people unable to charge for its usage. What did we get out of this?” he asks.

His acerbic answer: “We got Napster. I’ve heard many industry executives talk about how Napster is a killer application, how Napster accounts for 35% of all Internet traffic to universities. Is Napster some kind of tool that makes people more productive? No, it’s a way to steal music. Has it changed anything? No, it’s just a new distribution method that counteracts attempts to force people to respect copyright law.”

Apart from the lost wealth, Prof. Lerner warns of a potentially much longer-lasting negative consequence: that investors stop financing even good ideas for some years to come. He believes the information-technology revolution of the 1980s and ’90s might have arrived sooner if not for the bust that followed the 1968-72 boom in computer-stock issues.

In 1968 and 1969, young computer firms raised $1.5 billion in current dollars, puny by today’s standards but a dizzying sum at the time. Between early 1973 and mid-1978, just $200 million was raised. “To be sure, many firms that raised capital during the boom years had poorly thought-out business plans, or they were engaged in doomed battles with entrenched giants such as IBM,” Prof. Lerner and fellow Harvard academic Paul Gompers write in a coming book, “The Money of Invention.” “Investors may have soberly concluded that these firms had limited prospects. But other firms with `winning’ technology also found it difficult to raise capital. For instance, companies seeking to commercialize the personal computer and networking technologies that would exert such a revolutionary impact in the 1980s and 1990s also struggled.”

Whether a similar drought follows the latest bubble remains to be seen. Roger McNamee, general partner at Integral Capital Partners, a Menlo Park, Calif., investment fund, says, “I’m absolutely certain that before this is done, there will be business plans that are worthy and deserving that will not be funded at all.”

But whatever the future holds, the bubble has almost certainly enabled some companies with valuable technologies to obtain financing and flourish that otherwise wouldn’t have or would have taken much longer. Mr. McNamee recalls being offered a chance to invest in Sycamore Networks Inc. in 1999, which was developing technology for transmitting and managing data over fiber-optic lines. Mr. McNamee recalls that its valuation, in the hundreds of millions of dollars, seemed high for a company with little revenue to date; Sycamore lost almost $20 million on sales of $11 million the year before it went public. But given its management team and how much money its customers, the fiber-optic carriers, had raised in the stock and bond markets, Mr. McNamee figured Sycamore would be able to reach critical mass quickly. Indeed, in its past 12 months Sycamore has recorded revenue of $419 million and a modest profit.

Much of the tech bubble’s impact lies in how it helped old-economy companies avoid the dot-coms‘ mistakes, and in some cases galvanized competitors into acting more quickly.

Mr. Hale, of Zurich Group, recalls attending the World Economic Forum in Davos, Switzerland, two years ago. “CEOs of big, old-line companies were very frightened of the specter of these kids making this money, so when they got home from Davos they told their guys, `Get with it.'” Prof. Lerner had a business student who took a year off to help form a business-to-business exchange for machine-parts companies, but the venture failed when the hoped-for customers, alerted to the potential, formed their own exchange.

When Mortgage.com Inc. raised $56.5 million in an IPO in August 1999, it told investors, “We intend to use the Internet to expand our geographic scope to every potential mortgage borrower in the United States.” But though it grew to more than 600 employees, its losses mounted, and last fall, unable to find anyone who would fund its losses any longer, closed its doors. “The online mortgage industry has not been able to demonstrate its ability to deliver cost-effective mortgage loans to consumers at a profit,” Chairman Seth Werner said at the time. The former chief strategy officer, Jack Rodgers, saw his personal worth on paper at one point top $10 million. He ultimately got less than $500,000 out of the business that he spent eight years helping to build, and he hasn’t even paid off his own three mortgages totaling about $700,000.

But Mortgage.com’s loss was its brick-and-mortar competitors’ gain. The U.S. mortgage unit of the Dutch banking group ABN Amro had been mulling entering the busines of retail online mortgage lending. It got some valuable lessons in what not to do when Mortgage.com went into liquidation and put its assets up for sale.

ABN Amro Mortgage Group’s executive vice president, William Newman, says Mortgage.com was charging substantially less for loans than brick-and-mortar competitors. But apparently because of its efforts to serve all types of customers, it was spending just as much money as a regular mortgage lender to originate loans, and more when marketing expense was included. ABN Amro has decided to target only a narrow segment of the market: highly creditworthy borrowers who understand the mortgage process. Mr. Newman figures their applications will cost several hundred dollars to process, compared with $2,000 to $3,000 for a typical application, savings which can be passed on to the borrower. The only asset of Mortgage.com that ABN Amro elected eventually to buy was its Web address.

Many of these benefits would have happened anyway, and to be sure, there was a cheaper way to get them without annihilating billions in wealth and taking the economy to the brink of recession. But it wouldn’t have happened as quickly.

Michael Saylor, chief executive of MicroStrategy Inc., a data-mining software firm in Vienna, Va., experienced the boom and the bust in their full power. His company had been an obscure but profitable supplier of software that helped accountants at old-line companies like Kmart and Bank of America sift through their sprawling databases. But as the Nasdaq soared, he decided to spend millions — running up losses in the process — to turn his company into a personal intelligence service, providing hundreds of thousands of individuals with traffic, sports, weather and stock updates. “We took technology from the back office to the front office and it became 100 times more interesting, bigger and valuable,” says Mr. Saylor. His company’s value climbed to $25 billion from $400 million, and then, as the Nasdaq bubble deflated, came crashing down again.

“I would definitely rather have not had that much volatility,” he now says as he tries to return his company to profitability. “It’s caused a lot of gray hair and a lot of stress.” But he is hard-pressed to say how things could have been managed differently. Without the flood of risk-seeking capital, “you would not have nearly as much diversity, not nearly as much innovation, things would have gone not as fast. You need a bit of risk-taking on the part of the market.”

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Written by gregip

March 20, 2001 at 11:11 pm

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