John recalls his thinking during the extraordinary years of the ‘new economy’.
The years from 1996 – 2000 were an extraordinary era for a business economist. As a student, I had read about these outbursts of collective madness that seemed to have occurred every two or three generations since the beginning of modern economic history. To live through such events, meet the participants, and witness the psychology of mass hysteria at work was a remarkable, and in a sense privileged, experience.
Of course, there was no ‘new economy’, and the traditional conventions of accounting and rules of business success had not been repealed. But even in a protected academic environment, there were social and commercial pressures to subscribe to the fashionable nostrums which, for a brief interval, seemed capable of making everyone involved effortlessly rich. To tell students who flocked to dot.com startups that it would all end in tears was to be as imprudent as those who denied that there were witches in Salem, that the beginning of 1929 represented a new era of stable growth and unprecedented prosperity, or that 1950’s America was in imminent danger from a Communist conspiracy.
I was fortunate, having left Oxford in mid 1999, to be free to tell the truth. And, since not many people listened at the time, do not feel much embarrassment in reproducing some of the things I then said. (The full text of these articles is in the archive)
Extracts from debate with Lowell Bryan, McKinseys, Management Today, June 1999:
Everyone is rushing to grow through acquisition. And today’s question is indeed, are you going to buy or be swallowed up?
Tomorrow’s question, however, is whether any of this makes sense. Is today’s merger frenzy generated by some genuine change in underlying logic, which makes ever bigger corporations necessary. Necessary not to secure self protection in a world of self destruction, but necessary to perform the real functions of business – to serve customers better and in doing so make money for investors.
Or is this wave of acquisition simply the product of the ambitions of chief executives and their investment banker’s need for transaction fees? And will the next decade see the unwinding of many of the most spectacular acquisitions – as happened to the conglomerate mergers of the 1970s and the asset plays of the 1980s?
You say that – whatever you and I think – the ever-rising stock market proves that the conventional wisdom must be right. I’m sorry, it only proves that it’s the conventional wisdom. Your job – as consultant – and mine – as academic – is to appraise the conventional wisdom critically, not to repeat it.
So, I concede, the stock market is saying “it’s different this time”. Indeed the Dow Jones has gone from 10000 to 11000 in the course of this correspondence. If it goes on rising like that, it really will have been different this time, and – as many investors really believe – the old laws of business and economics will truly have been repealed. But I doubt it. Time will tell which of us is right.
Financial Times, 29 September 1999:
‘Lastminute.com was founded last April by two young entrepreneurs. Lastminute.com provides a website which allows buyers and sellers of last minute services, such as vacant seats on package holidays, to be brought together. But if we ask what is the replacement cost of this admirable facility, the answer is a good deal lower than the £400 million valuation which has allegedly been attributed to it ……’
‘On the most extravagant assumptions, it is hard to put the cost of replicating One2One at more than a quarter of the price Deutsche Telekom paid. The reality check of replacement cost introduces competitive dynamics into earnings projections. If earnings are so far above replacement cost, entry and rivalry will force these earnings down. (As a matter of fact, One2One has yet to make a profit.)’…
‘The current emphasis on earnings projections and neglect of replacement cost is sometimes justified by a belief that replacement cost is irrelevant: the first entrant to a market enjoys all the benefits of its subsequent growth. Our experience of business history is entirely otherwise.’ …
‘Almost all markets quickly become competitive: market leadership goes to those who enjoy competitive advantages: and high profits are the result, not of market expansion as such, but of strong and sustainable competitive advantages. Whatever else happens in the New Economy, the basic laws of market economics remain unchanged.’
Debate with Diane Coyle, Prospect, February 2000:
‘You begin by noting that there is a lack of clarity about what is meant by the New Economy. I agree. If all that is being said is that the US has enjoyed an abnormal period of growth in the 1990s, or that computer power is increasing at a rapid rate, then we can stop the debate here: we do not disagree.’
’But the claims of many proponents of the New Economy are much more grandiose. They claim that changes in information technology in general, and the growth of the internet in particular, constitute a discontinuity in economic life with few (if any) precedents in economic history. Moreover, this discontinuity will fundamentally change how we live our lives and the ways in which we do businesses. Consequently, many of our conventional views about the limits to economic growth and the nature of competitive advantage-even the principles of economics themselves-are now irrelevant. More specifically, American shares are still cheap, even though they are valued on a basis quite out of line with historical experience.’
Like you, I am sceptical about forecasting and I certainly would not say with confidence that the above assertions are untrue. But I can say with confidence that the current evidence in support of them is negligible.’
‘Students, journalists, business people all like to be told that the rules of the game have changed completely and the old knowledge doesn’t apply any more. It saves the bother of acquiring the old knowledge, assimilating it and applying it. It fills magazines and employs consultants. But I suspect there is life in the old knowledge yet.’
Financial Times, April 19, 2000:
‘Once upon a time, Uncle Sam had a good idea. Or, to be more accurate, his niece and nephew, Dot and Com, had a good idea. Dot and Com lived in California and spent most of the day surfing. Uncle Sam found it difficult to understand exactly what the good idea was: but he knew that Dot and Com were very clever, he admired Dot’s long legs and Com’s tan and their enthusiasm convinced him that their good idea would succeed.
So Uncle Sam went to see his banker, Mr M. Old Mr M had seen many enterprises come, and almost as many go. That had made him cynical, but also rich. Uncle Sam knew that Mr M would back the venture, because of his long and profitable relationship with Uncle Sam. In turn, Mr M would expect Dot and Com to live frugally and work every hour of the day for several years, until the business turned into profit, and perhaps even until it started to generate cash.
But old Mr M was buried beneath his last tombstone, and young Mr M had taken his place. Uncle Sam knew immediately that young Mr M was very different. Old Mr M had never been known to remove his jacket (even, Uncle Sam suspected, when he went to bed.) Young Mr M’s red braces were visible for all to see.
Banking was not as it had been, young Mr M explained. In the old days, new industries had needed large capital investments. The patriarchs whose portraits were on the wall of Mr M’s office had raised money for railroads and electric utilities.. They had built automobile plants and funded oil wells and airlines.
But today, Mr M explained, we live in a weightless economy. Knowledge based businesses don’t require large capital investments. They need money to pay salaries and consultancy fees while the good ideas fructify. They also need to cover their large advertising and public relations expenses. Everyone could see what railroads and automobiles were for, but good ideas today seem to require a lot more explanation. Still, these expenditures hardly compare with the costs of a steelworks or a gas pipeline.
Uncle Sam sympathised with young Mr M. He had been made redundant once or twice himself, and he knew what it felt like. What was Mr M planning to do, Uncle Sam asked, now that fledgling companies didn’t need bankers any more.
Young Mr M laughed. Although there was no paper on his desk, there were many paperweights. He explained that his firm had raised more money for new businesses in the last year than in the whole of old Mr M’s lifetime. Uncle Sam was puzzled. If these knowledge businesses didn’t need large scale investment, why was Mr M raising capital for them, and where was the money going?
Mr M laughed again. Poor old Uncle Sam just didn’t get it. Modern investment banking wasn’t about funding capital projects. It was about spotting entrepreneurship. Bright young people like Dot and Com deserved to be rewarded for their good ideas. Their friends should be rewarded for knowing them, and for introducing them to Mr M. And their advisers, like Mr M’s private equity division and Mr M himself, should also have a share of the action.
Mr M tapped a few numbers into his computer If Dot and Com’s idea was as good as Uncle Sam said, then it was worth…. he named a figure that took Uncle Sam’s breath away.
By now, Uncle Sam was beginning to understand. He was just very old-fashioned in thinking that banks and stock exchanges were there to finance investment. The purpose of modern capital markets was to give young people immediate access to the money their good ideas would produce in future. He started to think of the things that Dot and Com would be able to buy. Nice houses, celebrations on the beach. He hoped he could join some of them. Uncle Sam had thought he would give Dot and Com a helping hand. But now he realised that they would soon be helping him.
The values of the new economy were very different from those Uncle Sam remembered sharing with old Mr M. Fine residences and grand parties used to be things that came after your business had succeeded, not before. Another of old Mr M’s maxims was that a bird in the hand was worth two in the bush. Young Mr M calculated the net present value of the flock before the egg had hatched.
Times had indeed changed, Uncle Sam reflected, as he took the subway home. But one of Mr M’s answers still troubled him. Uncle Sam now understood where the capital being raised went to. But where had it come from?
Mr M had explained that there were two parts to the answer. Some of the money was derived from Uncle Sam’s pension fund. Uncle Sam’s trustees were putting his annual contributions into these start-ups, and even ditching shares in old Mr M’s businesses to find more cash for talented girls and boys like Dot and Com. Uncle Sam had always thought that pension funds were there to help old people supplement their incomes at the end of their working lives, not to help young people supplement their incomes at the beginning of their working lives, but he supposed that just showed how out of date his thinking was.
And net investment in the US stock market had been stimulated by a fall in savings and an increase in borrowings, largely from abroad. After all, since these good ideas were going to make everyone much richer in future, there was no need to put money aside for the future in the time-honoured way.
What would happen, Uncle Sam wondered, if Dot and Com’s good idea wasn’t as good as he and Mr M both thought it was? Who would pay his pension, and repay the foreign borrowings? Not to worry, he reflected. Dot and Com were good kids and he had a lot of confidence in them. A tear ran down his cheek. Uncle Sam had finally got it.’
Financial Times, 24 April 2000:
‘“Do the math”. The slogan comes from Jim Clark, creator of Silicon Graphics, Netscape and Healtheon. It has become the mantra of a generation of consultants and investment bankers. The new economy, they claim, requires new principles of valuation. …..
The rules of logic hold even in cyberspace, and so do the principles of economics. Profits are hard to earn in competitive businesses, and markets that are not competitive are usually regulated. The value of companies ultimately depends on their capacity to generate cash for their shareholders. Distant returns are uncertain. Share prices are very volatile, and investors need to be compensated for the associated risks. These simple truths are as valid in the new economy as the old.
By all means do the math. Isaac Newton, who could do the math better than anyone else in history, gave up an annuity of £650 per year to invest in the South Sea Bubble. In addition to the math, you need the econ, the pol, and perhaps the psychology.’