Changes in technology and financial markets may end up increasing the frequency of bubbles in the future.
SIZE ANDSPEED OF GLOBAL CAPITAL
Global capital moves faster and in greater volume now than at any time in measurable history, enabling investors to chase the greatest returns anywhere in the world, increasing volatility, and contributing to bubble formation.
The percentage of U.S. stocks owned by foreign residents has grown steadily over the decades. In 1960, just 2 percent of U.S. equities were owned by those abroad, about $9 billion. The share grew to almost 5 percent in 1980 and to 7 percent by 1990. The share of U.S. equities owned by foreign residents peaked in 2002 at 11 percent, amounting to $1.4 trillion.
More importantly, the movement of global capital, the inflows and outflows, has been accelerating. At the turn of the millennium, the quar- terly inflows from abroad were $194 billion and represented 1 percent of the total market value of the U.S. stock market, a record level since the Federal Reserve started collecting data in 1952. This was more than total inflows into mutual funds. To put this in historical perspective, the only previous period in which foreign inflows surpassed half this inflow was the brief period before the end of the last bubble of 1986 and 1987. The global growth in both the size and speed of capital movement has brought powerful benefits to businesses and investors to many parts of the world. At the same time, the trend also poses challenges to investors and governments that need to be recognized and analyzed. Now that capital flows are not just attracted to sectors that show remarkable re- turns, capital floods those sectors with astounding speed.
LARGERVENTURECAPITALINDUSTRY
Another development that will help fuel future bubbles is that the ven- ture capital industry is now far larger than in the past. Through each new wave of technology funding, from 1960, 1980 to 1990, the for- mer cottage industry has deepened not only its expertise in financing
new companies but also become a substantial global industry reaching
$100 billion. This tremendous size means that there is significant “pent up” capital always looking for extraordinary returns. The need to cre- ate large returns on so much money, will create powerful incentives to fuel the next bubble.
Despite the Internet bust, limited partners continue to invest heavily in venture funds. It is hard to know for sure how this will affect the industry dynamics. The venture funds will ultimately have to put that money to work. Without a bubble available to create money making opportunities, it is likely that the returns to those limited partner investors will be low. Al- ternatively, a bubble may arrive to channel that pent up capital.
A common lesson that many investors and venture capitalists seemed to draw from the Internet bubble as well as the PC bubble was not to stay away from bubbles the next time but to time them better in the future. The next time, many hope, they will get in and out ear- lier. Others hope that they will be able to maintain better discipline in their investment decisions but are fairly realistic about holding up against the momentum.
In addition, the growth of the venture industry may help spur the pace of innovation, which can also foster bubble formation. According to a study by Samuel Kortum and Josh Lerner, venture capital activity in an industry significantly increases the number of patents it produces. In the years leading up to 1998, when the study was done, the VC indus- try was an average of just 3 percent of the size of the R&D spending.
However, the study finds that venture capital accounts for 15 percent of industrial innovations.1So with far less spending they are able to gener- ate many more innovations. As the venture industry grows, this may spur innovation further.
ACCELERATINGINNOVATION
Investment bubbles related specifically to technology may increase in fre- quency because a growing share of the U.S. and global economy is dri- ven by this sector. Communications across borders and research disciplines may also be increasing the speed of innovation. Each new in- novation seems to have multiplied the areas for further innovation. Con-
sider the semiconductor: Within a few decades it enabled the computer, the PC, the Internet, wireless, and so forth. Each of these innovations spawns further innovative ideas and investment possibilities.
According to the U.S. Patent Office, 157,495 patents were granted in 2000, up from 90,365 in 1990 and 61,819 in 1980. Looked at another way, in 2000 there were 560 patents per 1 million people in the popula- tion of the United States, compared to 363 in 1990, 273 in 1980, and 317 in 1970.2
One sign of this accelerating innovative process is that the life-cycle of existing technology is shrinking. New technologies become obsolete in shorter and shorter periods. Scott McNealy put it humorously when he said, “The nice thing about technology is that is has the shelf-life of a ba- nana. It’s going to wear out, it will get used up.”3A study by the Federal Reserve determined this to be true statistically: the depreciation of goods, and particularly computers, has been accelerating dramatically over time, leading to an increasing need to invest.4
Corporations also increasingly view perfecting innovation as their only way to survive. According to Michael Cox, chief economist of the Federal Reserve Bank in Dallas, from 1917 until 1977 it took an average of 30 years to replace half the companies in the top 100. But between 1977 and 1998 it took just 12 years to replace half the firms. Of the 100 largest public companies in 1999, only five are survivors from the top 100 of 1917. Half the firms in the top 100 are newcomers, entering the list in just the past two decades.5That is a remarkable acceleration in
“creative destruction.”
These three factors—global capital movement, growing venture capi- tal industry, and accelerating innovation—are not stand alone forces.
They can reinforce each other as venture capital continues to fuel inno- vation and global capital movement is poised to flood the next sector that appears to generate frenzied returns. The interaction between these forces will certainly add strong pressures and will likely increase the fre- quency of bubbles. In the past there was hardly a year of economic growth that did not feature a bubble in some sector somewhere since 1950. In the future there may be multiple bubbles occurring at any one time. The bubbles of the future may compete with each other for atten- tion and for capital. We will live in interesting times.