Wednesday, March 10, 2010

A case and brief history of bubbles

by Andy Kessler:
Misallocation of capital is everywhere and anywhere a fallout of bad government policy. The South Sea Company, a government sponsored entity with a monopoly on trade, caused the South Sea Bubble in 1720.

The late '90s Internet love fest was crazy enough, driven by former FCC Chairman Reed Hundt's misguided telecom reform that had the effect of keeping data rates artificially high. This created a gold rush to install fiber and build applications that didn't make economic sense (though electronic commerce, online banking, as well as wireless and broadband deployment would eventually prove productive over the next decade). Bad policy meant capital got overallocated and too quickly, as momentum mutual funds (momos) and day traders furiously drove up stock prices of every company with dot-com in its name for no fundamental reasons. Wall Street trading was broken.

Then, adding insult to injury, Alan Greenspan and the Federal Reserve flooded the system with money, fearing that banks would face a run brought on by the Y2K problem. The problem and the run never happened. The money ended up in the market. Mopping up that money burst the bubble. The market bottomed out on Oct. 9, 2002, when the Nasdaq hit 1114.

And the world after 9/11? Unfortunately, the accounting scandals at Enron, WorldCom and elsewhere brought us the costly Sarbanes-Oxley law, adding a complex regulatory burden so that many companies fear going public. We also got a decoupling of research from investment banking because of an alleged conflict of interest, and a Federal Reserve whose nightmare fears of deflation ushered in a long era of cheap credit.

Instead of finishing what the dot-com era started to deliver—a productive, wealth-producing economy—capital was seduced into the financial lair of private equity and real-estate mortgages. Trillions were pumped into unneeded housing stock. Fannie and Freddie fanned the flames, and then fizzled and failed. And leveraged buyouts reigned. Even in 2007, one Blackstone private equity fund raised almost as much money as all of the venture capital industry.

It's been 10 long years since the economy has created real wealth, as opposed to easy-credit induced real-estate or paper wealth. Amidst all the current confusion over health care and tax rates and energy and banking reforms, maybe it's time that the market transitions back to investments that drive productivity and increase living standards rather than just paper profits.

I'm not saying the market should transition or it ought to—you don't tell the market what to do. As we know from one and 10 years ago, the market works in weird ways and makes these transitions in the fog of something else, in this case it's the Fed's life support that is misallocating capital. When that ends, look for new eras to begin.

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