Learning to Live with Bubbles

They're a fact of market economics, and they can lead to much good -- if managers understand and avoid the pitfalls. At the fifth anniversary of the popping of the Internet bubble, a long shadow remains over businesses and the economy: The cycle of creative destruction is not yet complete. A number of key measures, from the stock market to employment, remain far below levels reached in 2000. More strikingly, individual businesses are still fighting the same underlying strategic battle that confronted them during the bubble -- the disruptive effects of digitized information.

How so? The music industry is being transformed by Apple's iTunes. Television is facing pressures from digital video recorders, online downloads, and now the video-clip searching abilities provided by Google and others. Print media faces a challenge from blogs. Telecommunications continues to be altered by the rollout of voice over Internet protocol (VoIP). Electronic trading exchanges are altering the economics of stock markets. And radio frequency identification tags (RFID) are transforming the management of supply chains.

Emerging from the trough, we realize now that the bubble was not all froth and nonsense. It wasn't like the Dutch tulip mania of 1635, a purely speculative run-up in prices for exotic flowers with no underlying value created along the way. The Internet bubble, like so many business bubbles of the past, continues to create positive changes in business and consumer marketplaces. We have moved out of the hyperactive revolutionary period and into the slower, more significant, evolutionary phase.

BUBBLES AS R&D. The frenzy of business bubbles is like an overexcited learning exercise or a giant research and development effort. All the failures teach the marketplace what works and what doesn't. We learned at an accelerated clip about how the Internet could be deployed as a technology, what new business models might work, how consumer behavior can change and at what speed. What was proven wrong during the crash wasn't the overall vision. No, many of the ideas about how to profit from the vision and how long it would take to become reality were proven wrong. But the vision remains. The dot-com bubble followed historical patterns. Bubbles pop because they're the product of a cascade of bad investment decisions. But bubbles aren't attributable just to irrational exuberance -- although obviously that plays a role.

BUBBLE PATTERNS. In addition to the standard ideas of greed and irrational exuberance, bubbles are fueled by other unexpected forces. They're based on systematic distortion of information, which erodes managers' ability to distinguish the good, the bad, and the ugly. They're based on a competitive marketplace that feeds the frenzy and forces even the wise to jump into the game in order to meet their benchmarked returns. And lastly, they're based on the day-to-day decisions by investors that collectively oversaturate the entire market with capital, leaving a market with too much money chasing too few quality opportunities.

BUBBLES ARE EVERYWHERE AND ACCELERATING. Making sound business decisions is extremely difficult during tumultuous markets. And as we continue to see, the business challenges they introduce last for decades. Business bubbles are the driving force of capitalism, innovation, and change. They're the fuel for the creative destruction that's the engine of explosive change in our economy. Bubbles aren't aberrations to normal economic functioning. They occur all the time -- some big, some tiny. In recent decades alone we've seen business bubbles in biotechnology, PCs, and semiconductors, and in regions such as Southeast Asia. Many more bubbles lay ahead. Since the 1960s, there has hardly been a year where there has not been a bubble somewhere.

In fact, we're likely to see a lot more of them in the future, as the speed and scale of both global investment and innovation accelerate. Several bubbles are already percolating in China, in nanotechnology, VoIP, real estate, private equity, hedge funds, US debt, and perhaps elsewhere so far undetected.

COSTS AND RISKS. For all the benefits bubbles can produce by financing giant shifts in technology and new market opportunities, they do so at great costs and risks. The immediate costs are the obvious and painfull loses that occur when they crash. The risks are far larger and more ominous. Since the 1980s, bubbles have repeatedly brought the US or world economy close to collapse (LDC Debt, S&L Crisis, Asian Miracle turned Asian Economic Crisis, Russian Debt Crisis, Long-Term Capital Management, Argentina, the Internet). Each time we narrowly avoided disaster, frequently thanks to a complex rescue package. Fortunately, so far they worked. We may not be so lucky in the future.

Business managers must improve their ability to navigate these periods of innovation and change by recognizing the patterns and avoiding some basic but common mistakes. Those who plan now for the next big bang can avoid making the major mistakes we saw so often in the last go-round.

For more on what drives bubbles see a book I wrote on the topic called Frenzy. I really like it and other people seem to as well.