Economic Scene: Comparing Nasdaq and Tulips Unfair to Flowers

By HAL R. VARIAN, New York Times, February 8, 2001

WAS the Nasdaq bubble yet another example of tulipmania?

The answer is no, but not for the reason you think. There is a good argument that the run-up in Dutch tulip prices in the 1630's was more or less rational. But there is no such excuse for the Nasdaq bubble of 1999 that burst in the spring of 2000.

The Brown University economist Peter Garber's monograph "Famous First Bubbles" describes the revisionist view of tulipmania: it was not so crazy after all. His argument rests on these three points:

Mr. Garber goes on to say that the Dutch authorities deplored the "obviously unsafe financial speculation in which a legitimate business had suddenly degenerated into a bizarre form of gambling."

After the prices collapsed, the Dutch courts did not even consider the tavern bets as contracts and refused to enforce them.

One commonly cited piece of evidence for the irrational exuberance in the tulip market is the argument that a single bulb sold for the "price of a fine house" at the peak of the speculative frenzy. But in 1987 a small quantity of prototype lily bulbs sold for the equivalent of $693,000 at today's prices. Perhaps that is less than the price of "a fine house" in Silicon Valley, but it is clear evidence that rare varieties of flower bulbs are still pricey.

What about the Nasdaq bubble? Until January 1999, the Nasdaq and the Standard & Poor's 500-stock index faithfully tracked each other. But at that point, they began to diverge. The run-up in Nasdaq prices peaked in March 2000, and prices have since fallen significantly. But even now, someone who invested in the Nasdaq index in early January 1999 is still ahead of a similar S.& P. investor.

Plenty of observers warned that the dot- coms were overvalued. To choose just one example, Arnold Kling, author of an entertaining and instructive online economic newsletter called "Arguing in My Spare Time" (www.arnoldkling.com), wrote in July 1999 that Yahoo's stock price valuation at that time could be justified only if it eventually received 24 billion page views a day, which meant that every man, woman and child on earth would have to go to it four times each and every day.

When you can sell stock in a company for more than it costs to create it, you tend to see lots of new companies. Indeed, there were more than 190 Internet initial offerings backed by venture capital in 1999, up from 23 in 1998 and 15 in 1997. This wave contributed to a 63 percent return for venture firms in that period, but investors who bought those offerings did not do nearly so well. This classic Wall Street question is as relevant in 1999 as it was in previous booms: Sure, the brokers all bought yachts, but where are the customers' yachts?

Just as tulip bulb prices fell rapidly as supply increased, the stock prices of Internet companies fell rapidly as the number of offerings rose by a factor of 12. It has been argued perhaps erroneously that the price of tulip bulbs bought at the peak of the bubble fell more than 90 percent. Well, there are plenty of Internet companies that suffered such stock price declines. And unlike the bar bets on tulip bulbs, the prices of the Internet companies were set on organized financial markets.

Why did the Nasdaq bubble occur? Several factors were at work. The slogan for initial offerings in this period "If it's thin, it's a win" meant that offering only a small fraction of the company for sale often resulted in a huge run-up the first day. Jay Ritter, a finance professor at the University of Florida, calculates that only 22 percent of the shares of new offerings were available to the public in 1999-2000, compared with a historical average of about 32 percent.

These thin offerings meant the entire company's value was determined by the optimists who bought the relatively small number of shares issued. Furthermore, the small number of liquid shares available made it hard for the pessimists to sell short the overvalued stocks. The rationing of new issues may have contributed to the excessive valuations, but there is no obvious policy response I doubt that authorities would want to regulate how much stock companies choose to issue.

Other possible culprits in the Nasdaq bubble are the commentators who emphasized winner-take-all forces in high-technology industries. But the obvious corollary to winner take all is loser get nothing, and there will inevitably be many more losers than winners. It is true that there are fundamental economic reasons only a few companies end up dominating certain high-technology industries, but this fact shows only that investment in such industries is highly risky, not that it is a sure thing.

I would argue that the driving force behind the rise and fall of the Nasdaq was simple competition. In 1635, unusual varieties of tulip bulbs were valuable because they were scarce. But in 1999 there was no fundamental scarcity of new business models for dot- coms. The result was an intensely competitive environment, where it has been extremely difficult to make money.

There was, ultimately, an inherent contradiction in the Internet hyperbole of 1999- 2000. The Internet was supposed to remove all barriers to entry, encourage competition and create a frictionless market with unlimited access to free content. But, at the same time, it was supposed to offer hugely profitable investment opportunities. You do not have to have a Ph.D. in economics to see that both arguments are rarely true at the same time.


Questions:

  1. Professor Varian points out that the pricing of the tulip bulbs in the seventeenth century did not occur in an organized market.  While the trading of Internet stocks did occur on an organized market, it may be argued that there were some fundamental aspects of a competitive market that were lacking in the market for some Internet stocks as well.  Present this argument.  (Hint: Look at the definition of a perfectly competitive market.)
  2. Go to http://arnoldkling.com/~arnoldsk/2001_01_28_barchive.html.  Explain why Arnold Kling believes that OpenWave is a bubble stock.  Comment critically.