Global Policy Forum

By Steven Pearlstein

Mention the Bubble Economy and it conjures up images of shredded documents and half-built Houston mansions, depleted pension accounts and executives being led off in handcuffs. It did not start out that way, and now, as households and investors sift through the ruins, the same question rings over and over: How could this have happened?

While it was going on - roughly from 1995 through 2000 - the Bubble Economy was known as the new economy, and nearly everyone thought it was a marvelous thing. Billions of dollars poured in to the United States from all over the world from people hoping to get in on the ground floor of the Internet, which held the promise of transforming not only the economy but also life as we knew it.

Unemployment nearly disappeared, and hot companies projected shockingly high annual growth rates. Stock prices rose higher and faster than ever before, turning geeks and secretaries into millionaires and making the ups and downs of the Nasdaq a national obsession. Respected economists declared that a revolution in productivity had rendered the economy recession-proof. Now, of course, it is clear that the bubble was neither real nor enduring. Twenty months after the world's largest economy tipped into recession, it is barely growing despite rising productivity. Stock prices are back where they were nearly five years ago. And nobody is confident of how much of the revenue and profit growth during the bubble was real and how much was accounting fiction.

Where were the safeguards that were supposed to warn against the dangers and prevent the excesses? Why did otherwise honest people resort to obfuscation, game-playing and outright fraud just to keep going?

Many of the key people involved in the economy appear to have gotten so caught up in the euphoria, and blinded by the financial rewards dangled in front of them, that they stopped doing their jobs, or convinced themselves that the nature of their jobs had changed. Foremost were the executives, who began to focus more on managing their stock prices than managing their businesses. They were encouraged by pension and mutual fund managers who shed their roles as patient custodians of capital to make it big in the quarterly rankings game. They were egged on by a money culture that lionized chief executives who could deliver quarter after quarter of double-digit earnings growth.

Corporate directors also grew so comfortable with the pay and status that the bull market had conferred on them that they became even more quiescent than they had been before.

There were the accountants who set their sights on becoming strategic partners and advisers to the executives whose books they were auditing, forsaking their traditional role of looking out for the interest of shareholders.

And it was during this period that stock analysts began to think and act like investment bankers, investment bankers like venture capitalists and venture capitalists like masters of the financial universe.

"In all the euphoria of the bubble, the gatekeepers were so unwanted that even they began to see their roles as redundant," said John Coffee Jr., a corporate law expert at Columbia University. "They were paid handsomely to look the other way, and many did."

A bit harder to explain is the acquiescence of regulators who might have earned medals had they used their still considerable powers to blow the whistle on some of the more egregious examples of corporate fraud that many sensed was going on. The same goes for business and financial reporters who suspended their natural skepticism to join the cheerleading squad.

If any one of these groups had acted the way they were supposed to and blown the whistle, the bubble would probably never have grown so big, or perhaps never developed at all, observers say. But it is in the very nature of a bubble that the lapses are simultaneous and widespread.

Also crucial to this system failure was the belief that because of globalization, deregulation or new technology, the world had changed so much that the old rules need no longer apply. Suddenly bribes became incentive-based compensation, lies became aggressive accounting and conflicts of interest became "synergies." Little indiscretions by one company spawned little ones elsewhere - and in time gave way to bigger ones in places where the corporate culture was most accommodating.

"As long as everyone was making money hand over fist, people were willing to overlook things," said Richard Sylla, a financial historian at New York University.

Of course, not everyone bought in to the mania. There were warnings that the prices were too high, the underlying assumptions ridiculous, the books cooked. Detractors included respected investors and money managers such as Warren Buffett of Berkshire Hathaway, the hedge fund manager Julian Robertson Jr., of Tiger Management, and Bill Miller, who runs the mutual fund Legg Mason Value Trust.

But during bubbles, people pay more attention to profits than to prophets. And driving the market boom, in large part, was a flood of investment capital. By the mid-1990s, the U.S. economy was awash in it, partly the result of the democratization of finance in the past two decades, which had driven up the percentage of American households that own stock from less than a quarter to more than half.

The investment surge also coincided with the arrival of the baby boom generation into that period of life when incomes are high and money starts getting saved for retirement. Much of that money ended up in stock mutual funds, which went from taking in about $125 billion in new money in 1995 to $300 billion in the peak year of 2000.

In addition, there was a flood of foreign money from investors burned in the Asian financial meltdown or disillusioned by Europe's slow progress in deregulating its economy and reforming its labor markets. From 1995 to 2000, $1.2 trillion more investment capital flowed into the United States than flowed out. Some of that money went directly into the stock and bond markets; but just as much came in the form of the direct purchase of American companies by foreign corporations.

Both types contributed significantly to the surge in stock prices, in the process lowering the cost of capital for U.S. companies and stoking over-investment in new companies, plants and equipment. The other crucial bubble ingredient was a new and economically transforming technology. The railroad, electricity, the automobile and the radio all spawned investment bubbles when first introduced, with each bubble giving way to a market panic or crash - and revelations of corporate fraud and misconduct. Historically, the pattern each time was roughly the same and ended with virtually none of the long-term investors making money. In the case of the American railroads, for example, so much was spent on duplicate tracks and excess rolling stock that it was not at least until the 20th century that the industry finally turned a collective profit. In the case of the Internet, one need look no further than the 75 percent decline in the Nasdaq to understand that very little of the economic benefit of this new technology has flowed to any but the earliest investors. In the end, a key segment of society did profit from the bubble. According to J. Bradford DeLong, an economic historian at the University of California at Berkeley, consumers are the big winners. They enjoy the low prices that flow from ruinous competition and reap the benefit of improved products and services that result when companies use new technology to operate more efficiently.

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