Stock market booms and busts are almost as old as the Republic. William Duer, a signer of the Articles of Confederation and a friend of Alexander Hamilton, brought about the first U.S. stock market crash in 1792. A pool of speculators organized by Duer bet heavily with borrowed money on pushing bank stocks into the stratosphere. The speculative frenzy came to an end when adversaries created a credit squeeze and popped the bubble. Duer was thrown in debtor's prison where he died several years later.
Bubbles are fascinating tales. But what transforms the normal propensity to gamble in stocks into a gravity-defying speculative mania? How is it that investors during Web mania thought a price-earnings multiple of 100 was conservative, 1,000 plausible, and infinity conceivable? The most common explanation is that the mass of investors simply took leave of their senses. In a now legendary phrase, with greed run amuck and morality bankrupt, investors suffered from "irrational exuberance."
No doubt enthusiasm spiraled out of control during the '90s boom. But widespread speculation often emerges during times of major innovation and technological progress. Take Tulipmania in 17th-century Holland. The Dutch dominated the new market for tulips in Europe. The highest tulip prices were for rare varieties, and the demand for these beautiful bulbs was driven by French fashion.
A growing auto industry, the rise of mass production techniques, and the spread of electricity propelled the economic boom before the 1929 stock market crash. The longest economic expansion in U.S. history, the 1990s prosperity, was largely powered by substantial productivity gains as companies learned to exploit the efficiency promise of information technologies. However, at some point it becomes especially difficult for investors to "guesstimate" tomorrow's profits during a major transformation—and a bubble forms.
Monetary economics also offers some insight into why prices of speculative stocks can reach wacky heights during a bubble—and fall so sharply later on. Internet stock prices soared as investors chased a scarce commodity—a limited number of Internet shares—during the trading frenzy. For instance, Excite had only 7 million publicly traded shares compared to 671 million for Disney. But Wall Street investment bankers worked round the clock to bring new economy stocks to the market. The supply of Internet equity increased dramatically, and prices eventually plunged. In a sense, just like the money supply, the Internet "currency" depreciated with Wall Street running the equity presses.
Whatever happened in the late 1990s—irrational greed or rational speculation—the aftermath has been painful. Fortunes have been lost and executives charged with fraud. Nevertheless, the bubble left a positive legacy. Thanks to a massive investment in information technologies and in reorganizing the workplace, the economy is more productive and efficient than before.
