One of the strange things about history is how certain periods from long ago can seem recent, while some events that just happened, relatively speaking, can appear ancient. As these words are being written, President George W. Bush has declared war on terrorism, and American warplanes are heading for Central Asia. Suddenly the Cold War, with its attendant undercurrent of fear, feels a lot closer, while the carefree 1990s seem like a distant age. It is too early to judge the ultimate historic significance of the terrorist attacks that were carried out on the World Trade Center and the Pentagon on September 11, 2001, but one thing is clear: they changed America’s view of itself. The belief in U.S. military and economic invulnerability, which grew stronger by the year during the 1990s, until it was taken for granted by many, has been violently undermined. In the wake of the attacks, America’s attention has shifted from the secondary human concerns that dominated during the 1990s boom (saving for old age, getting rich) to the primary matters of human survival (staying safe, providing a livelihood for one’s family).
Already, it is hard to fathom that just a couple of years ago many intelligent Americans believed that the marriage of computers and communications networks had ushered in a new era of permanent peace and prosperity. Depending on which Wall Street or Silicon Valley guru you listened to, the Internet was the most revolutionary development since the electric dynamo, the printing press, or the wheel. The most striking manifestation of this thinking was the extraordinary prices that people were willing to pay to invest in Internet companies. In nearly every sector of the economy, entrepreneurs, many barely out of college, were rushing to establish online firms and issue stock on the Nasdaq, which was heading upward at a vertiginous rate. Names like Marc Andreessen, Jerry Yang, and Jeff Bezos were being uttered with awe.
In March 1999, Priceline.com, an Internet company that operated a site on the World Wide Web where people could name their price for airline tickets, was preparing to do an initial public offering (IPO). In order to introduce Priceline.com’s executives to Wall Street analysts and fund managers, Morgan Stanley, the investment bank that was managing the IPO, hired a ballroom at the Metropolitan Club, at 1 East Sixtieth Street, a fitting location. The Metropolitan, which John Pierpont Morgan founded and Stanford White designed, is a lavish remnant of a previous gilded age. Four stories high, its white marble exterior is fronted by six Roman columns and an ornate cornice. After the guests had picked at their lunch, Richard S. Braddock, Priceline.com’s chairman and chief executive, told them that his firm had the potential to revolutionize not just the travel business, but automobile sales and financial services, too. This was a grand claim from a start-up that had been in business for less than a year and employed fewer than two hundred people, but nobody in the room queried Braddock’s presentation.
By the standards of the time, Priceline.com had impressive credentials. Jay S. Walker, the company’s founder, was a Connecticut entrepreneur who had already made one fortune by peddling magazine subscriptions in credit card bills. Braddock was a former president of Citicorp, and Priceline.com’s board of directors included Paul Allaire, a former chairman of Xerox Corporation, N. J. Nicholas Jr., a former president of Time Inc., and Marshall Loeb, a former managing editor of Fortune magazine. William Shatner, the actor who played Captain Kirk in Star Trek, had appeared in a series of popular radio ads for the firm. Morgan Stanley’s star analyst, Mary Meeker, recently dubbed “Queen of the ’Net” by Barron’s, the weekly investment newspaper, had helped coach the Priceline.com team for their presentation, and she was sitting in the back of the room as they spoke.1
The word on Wall Street was that Priceline.com would follow the path of America Online, Yahoo!, and eBay to become an “Internet blue chip.” The only question people in the investment community were asking was how much stock they would be able to lay their hands on. Underwriters reserved Internet IPOs for their most favored clients. Other investors had to wait until trading started on the open market before they could buy any stock. On the morning of March 30, 10 million shares of Priceline.com opened on the Nasdaq National Market under the symbol PCLN. They were issued at $16 each, but the price immediately jumped to $85. At the close of trading, the stock stood at $68; it had risen 425 percent on the day. Priceline.com was valued at almost $10 billion—more than United Airlines, Continental Airlines and Northwest Airlines combined. Walker’s stake in the company was worth $4.3 billion.
Airlines like United and Continental own valuable terminals, landing slots, and well-known brand names—not to mention their planes. Priceline.com owned some software, a couple of powerful computers, and an untested brand name. Despite this disparity, few on Wall Street were surprised by Priceline.com’s IPO. Such events had become an everyday occurrence. The New York Times didn’t think the story merited a mention on the front page of the next day’s edition and instead relegated it to the business section. “It doesn’t matter what these companies do or how they are priced,” David Simons, an analyst at Digital Video Investments, told the paper. “Each new Internet IPO is nothing more than red meat to the mad dogs.” Penny Keo, a stock analyst at Renaissance Capital, saw things differently. “We like Priceline’s business model,” she said.2
This was an interesting statement. Priceline.com started operating on April 6, 1998. By the end of the year it had sold slightly more than $35 million worth of airline tickets, which cost it $36.5 million. That sentence bears rereading. Here was a firm looking for investors that was selling goods for less than it had paid for them—and as a result had made a trading loss of more than a million dollars. This loss did not include any of the money Priceline.com had spent developing its Web site and marketing itself to consumers. When these expenditures were accounted for, it had lost more than $54 million. Even that figure wasn’t what accountants consider the bottom line. In order to persuade the airlines to supply it with tickets, Priceline.com had given them stock options worth almost $60 million. Putting all these costs together, the company had lost more than $114 million in 1998.
How could a start-up retailer that was losing three dollars for every dollar it earned come to be valued, on its first day as a public company, at more than United Airlines, Continental Airlines, and Northwest Airlines put together? To answer that question we must investigate what the nineteenth-century British historian Charles Mackay called “the madness of crowds.”3 Few investors, acting in isolation, would buy stock in a company like Priceline.com. To be willing to take such a risk, people needed to see others doing the same thing—and see them making money doing it. This is exactly what happened. Investors who bought stock in early Internet companies like Netscape, Yahoo!, and Amazon.com made a lot of money—at least for a while. None of these firms could boast much in the way of revenues when they went public, let alone profits, but that didn’t seem to matter. Seeing what was happening, other people started to buy Internet stocks, and other types of stocks too, not because the underlying companies were good businesses with solid earnings prospects, but simply because stock prices were going up. As history has repeatedly demonstrated, this is the point when a rising market turns into a speculative bubble.
Speculation, according to the McGraw-Hill Dictionary of Modern Economics, is “the act of knowingly assuming above-average risks with the hope of gaining above-average returns on a business or financial transaction.”4 There is no settled definition of a speculative bubble. Like pornography, it is easier to spot one than to define it. Broadly speaking, if the price of an asset—a stock, a house, a gold ring, or any other item of value—rises beyond anything that can be justified on economic grounds, and then keeps on rising for an extended period, it is a speculative bubble.
All speculative bubbles go through four stages, each with its own internal logic. The first stage, which is sometimes referred to as the “displacement,” starts when something changes people’s expectations about the future—a shift in government policy, a discovery, a fabulous new invention. A few well-informed souls try to cash in on the displacement by investing in the new vehicle of speculation, but most investors stay on the sidelines. The early investors make extremely high returns, and this attracts the attention of others. Next comes the boom stage, when prices are rising sharply and skepticism gives way to greed. The sight of easy money being made lures people into the market, which keeps prices rising, which, in turn, attracts more investors. Eventually, those upstanding citizens who haven’t joined in the festivities feel left out. Not just left out. They feel like fools. If their daughter’s boyfriend, who does nothing all day but sit around and play with his computer, can make fifty thousand dollars on his America Online stock, why can’t they? Boom passes into euphoria. Established rules of investing, and often mere common sense, are dispensed with. Prices lose all connection with reality. Investors know this situation can’t last forever, and they vie to cash in before the bubble bursts. As Charles Kindleberger, an MIT economic historian, wrote in his book Manias, Panics, and Crashes: A History of Financial Crises, “Speculation tends to detach itself from really valuable objects and turns to delusive ones. A larger and larger group of people seeks to become rich without a real understanding of the processes involved. Not surprisingly, swindlers and catchpenny schemes flourish.”5 Finally, inevitably, comes the bust. Sometimes there is clear reason for the break; sometimes, the market implodes of its own accord. Either way, prices plummet, speculators and companies go bankrupt, and the economy heads into recession. A few months later, everybody looks back in amazement, asking: “How did that happen?”
The Greater Fool Theory of investing provides part of the answer. Few investors really believed that Priceline.com was worth $10 billion. On page three of Priceline.com’s prospectus—the legal document that all companies have to file with the Securities and Exchange Commission before they issue stock to the public—the following headline appeared in bold type: “We Are Not Profitable and Expect to Continue to Incur Losses.” Other headlines in the first twenty pages included: “Our Business Model is Novel and Unproven”; “Our Brand May Not Achieve the Broad Recognition Necessary to Succeed”; and “We May Be Unable to Meet Our Future Capital Requirements.”6 Short of printing a warning from the Surgeon General, it is hard to see what else could have been done to alert the public to the dangers of investing in Priceline.com. Investors ignored these warnings because they had persuaded themselves that there would always be somebody else, a greater fool, ready to buy their Priceline.com stock at a higher price. For a while they were proved right.
The Greater Fool Theory explains how the bubble sustained itself but not why it started or what it signified. Those questions can only be addressed by placing what happened in its proper historical context. The stock market boom, which extended well beyond Internet stocks, was about more than day traders trying to get rich on the Nasdaq and twenty-four-year-old computer science graduates trying to become the next Bill Gates. It was about both of those things, of course, but it was also about a lone superpower that believed it had discovered the secret of eternal prosperity. It was about a group of pundits promoting the next “big thing.” It was about Wall Street bankers eager to cash in on an unprecedented source of revenues. It was about newspapers, magazines, and television programs that pumped enough hot air into the Internet bubble to float a blimp. It was about economists and other “experts” who refused to learn the lessons of history. It was about a chairman of the Federal Reserve who had convinced himself that miraculous things were happening to the American economy. Above all, it was about ordinary Americans, enticed by the prospect of instant wealth, parting with their hard-earned money for worthless pieces of paper. In short, the 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, therefore, is the underlying subject of this book.
Gold rushes are an established feature of American history. In 1849, the year after the United States seized California from Mexico, gold was discovered in the Sierra Nevada Mountains. “At once a host of fortune hunters poured forth, some by sea and some by overland trail, to the canyons and gulches where nuggets could be washed out in pots and pans,” Allan Nevins and Henry Steele Commager recounted in their classic history of the United States. “The mountains filled with roaring camps; San Francisco sprang overnight into a lusty little metropolis, full of vice, luxury, and energy; and California was converted in a twinkling from a sleepy, romantic community of Spanish-American ranchers into a hustling and populous commonwealth of Anglo-Saxons.” The discovery of gold on the Internet can be dated, with some precision, to August 1995, when Netscape, the maker of the Netscape Navigator Web browser, held its IPO. Like the strike in the Sierra Nevada, the Netscape IPO attracted a host of prospectors, but they bore little resemblance to the forty-niners. Instead of illiterate farmers, they were mostly highly educated professionals, and they came armed, not with picks and shovels, but with Harvard MBAs and subscriptions to The Wall Street Journal. As for vices, any that they had were hidden behind a bland façade of chinos and caffe latte. And unlike the Californian gold rush, the Internet mania was not geographically confined. It started out in Silicon Valley but spread to all corners of the country, all age groups, and all social groups with enough money to invest in the stock market.
This book tracks the development of the Internet bubble, and the broader stock market boom of the late 1990s, from the period immediately after the Second World War, when scientists had the first inklings of a decentralized communications network that would be beyond the control of any single authority. The Internet is often portrayed as a triumph of American private enterprise, but that is a myth. The U.S. government designed and built the Internet, and a European academic invented the application that turned it into a mass medium. Even in the mid-1980s, when the Internet had been up and running for almost two decades, most companies dismissed it as an obscure research tool. Not until the early 1990s, when millions of people around the world were already using the network to communicate with each other, did the private sector show much of an interest.
When Wall Street and corporate America did discover the Internet, they adopted it with the zeal of converts, and the bubble started to inflate. Once that happened, the process was self-reinforcing, with everybody involved trapped in the peculiar competitive logic of a speculative boom. In elementary economics textbooks, competition forces people to act rationally, and it also leads to an efficient allocation of resources. But in the real world, where people are judged relative to their peers, competition can have perverse effects. The venture capitalists that invested in Pets.com and Webvan didn’t necessarily believe the Internet was the best way to sell pet food and groceries, but they knew that if they didn’t finance these firms their competitors would. If the Nasdaq kept going up, and few doubted that it would, their rivals would be able to cash in their investments at a profit after the planned IPO. In such circumstances, the “sensible” thing to do was to keep pouring money into the Internet sector. Consequently, virtually any company with the suffix “.com” after its name could raise money. Investment bankers and mutual fund managers faced similar incentives. If they refused to have anything to do with Internet companies, as some of them did, at least in the early stages, their performance suffered compared to that of competitors who were managing Internet IPOs and buying Internet stocks.
Journalists weren’t immune to the logic of the bubble. In the early stages of a speculative boom it is easy for a financial columnist to be a skeptic, but after a year or two of rising prices, most readers get tired of pieces predicting a crash. The news is that investors are getting rich. Other people want to know how to mimic them; editors want to satisfy this demand. Tip-sheet journalism replaces probing reporting—a process that becomes more advanced the longer the bubble persists. By the euphoria stage, most observers have a vested interest in avoiding stating the obvious—that delusion has replaced reality. Journalists and media companies that are supposed to be objective are themselves benefiting from the bubble. Ditto economic policy makers. Nothing improves the reputation of a Fed chairman or a Treasury secretary like a soaring stock market and a booming economy.
With nobody left to prick them, speculative bubbles tend to go to extremes. A few weeks after Priceline.com’s IPO, its stock reached $150, at which point the tiny company was worth more than the entire U.S. airline industry. Two years later, the stock was trading at less than $2, and the entire market capitalization of Priceline.com would not have covered the cost of two Boeing 747s.
But that is getting ahead of our tale.