The Internet Boom as a System
April 12, 1999
May not be redistributed commercially without the author's permission.
When I studied economics at MIT, we were next door to the "systems group," for whom economists had only contempt. The systems theorists were known for making pessimistic long-term forecasts, particularly about energy and the environment.
Economists had two major problems with the systems theorists. One was that the systems theorists ignored the role of prices in resource allocation. The other is that at a time when the best statistical models of the economy tended to be accurate for only a few quarters, the systems theorists were publishing forecasts for decades ahead based on second-rate models.
Systems theorists look at the direction a process is going. Factors that tend to keep the process moving in the same direction are called reinforcing mechanisms. Factors that tend to stop the process are called limiting mechanisms.
Economist Herbert Stein has a comment to the effect that "Things which cannot go on forever eventually tend to stop." That is how Yogi Berra would summarize systems theory.
I believe that the language of systems theory is useful for describing the interplay between expectations and reality in the economy. That is, instead of imposing the doctrine of rational expectations, we should think of expectations as a system. As long as expectations are fulfilled, this will reinforce the current process by which people form expectations. However, the actual constraints of economic processes may become a limiting mechanism when expectations become unrealistic.
There is too much uncertainty in the economy for people to be able to make accurate long-term forecasts. However, forecasting methods that are quickly rendered implausible by events are likely to be discarded in favor of other methods. Thus, of all the possible ways that people might have to form expectations, the methods that will receive positive reinforcement will be those which are at least somewhat self-fulfilling.
For example, suppose that people believe that Alan Greenspan is going to succeed in controlling inflation. That expectation will be somewhat self-fulfilling, because it will lead firms to hesitate to raise wages and prices. This reinforces Mr. Greenspanís apparent ability to control inflation. Eventually, however, the reality may be that Mr. Greenspan is unable to control inflation. If inflation does break out, people will lose confidence in Mr. Greenspan's abilities, and this may lead to further acceleration of inflation. In that case, the system of expectations and inflation would develop momentum in the direction of higher inflation.
Many economic policy decisions are more likely to be effective if they are believed to be effective. For example, if speculators believe that a government can be successful at propping up the value of its currency, then intervention in the exchange market will work, even though in today's currency markets the volume of private capital flows swamps the volume of official activity in the market.
I suspect that the same holds true for monetary policy. That is, comparing the volume of private activity in the money market, it would be quite rational to take the view that the trading account of the Federal Reserve is too small to affect market interest rates. Nonetheless, market participants do believe that the Fed controls interest rates, and this belief in turn helps to reinforce the Fed's leverage in the markets.
Another example of somewhat self-fulfilling expectations is the belief that the Internet is going to generate extremely valuable franchises that take advantage of "winner-take-all" network effects. This belief will cause people to be willing to invest heavily in the initial market leaders, which reinforces the ability of those companies to attract talent and to acquire or drive out competitors through sheer financial power.
The reality could turn out to be that the underlying economics of the Internet favor a diffusion rather than a concentration of economic power. The Internet may permit companies to become more specialized and to divide markets into finer and finer niches. If one company takes a lead in a broad market, that company will be ripe for attack. When it is attacked, it may be unable to defend the broad market, and it may be forced to retreat to a niche. If this is true, then the momentum toward greater concentration in the Internet market ultimately will slow down. This in turn will cause investors to place relatively less value on market leaders, which will reinforce the ability of smaller companies to compete against them.
The success of day traders in new Internet stocks is another example of a system with momentum generated by positive reinforcement. Assuming that day traders on average take more long positions than short positions, they will make money as long as stocks are rising rapidly. This will tend to induce more people to attempt to become day traders. Because the day traders tend to be net long on average, more day traders will tend to lead to rapidly rising stock prices.
What are the limiting mechanisms in this system? One limiting factor is that the supply of new money to feed the Internet stock frenzy is not infinite. Another limiting factor is that the supply of companies attempting to go public is likely to increase. Eventually, there may be more public offerings than the system can support.
As of this writing, the upward momentum of the Internet boom is very powerful. However, the extent to which the boom depends on its systemic momentum should give one pause. One can imagine a situation in which Internet stock prices level off, day traders then tend to lose money, and as day traders exit the stock prices tend to fall, leading to more losses and more exits. Once the system changes direction, the momentum downward could be even more powerful than what we have seen going upward.
In short, the Internet stock boom can be viewed as a system with very strong reinforcing mechanisms. Having gathered momentum, it may be propelled forward very powerfully. However, it is quite possible that some day those same powerful forces will be aligned in the opposite direction.