Millennial Alchemy

Shortly before the turn of the millennium, public opinion came to be that the Internet represented a new economic order, unconstrained by the eco­nomic laws of the physical universe.

A few brave souls applied lessons gleaned from economics, manage­ment science, and business experience to this daunting task. Most, however, relied on the time-honored principles of alchemy; they would turn base ideas into golden companies merely by placing them on the Internet. Citizen Microsoft felt itself threatened by the new alchemy. Its leadership and popularity began to slip away, as various upstarts nipped at its heels. Microsoft fought back to secure its hard-earned position as kingpin of computing. In its quest for continued supremacy, Microsoft destroyed its challengers, dominated its partners, harmed its captive con­sumers, tried to curb all innovation that it couldn’t control, and earned the ire of the government—though hardly that of the public. Its own quest for Internet gold thus relied on a scheme at least as ancient as alchemy: a campaign of plunder.

The widespread Internet alchemy and Microsoft’s unique form of plunder fed off each other, as revelations from the trial powered the bubble, and the bubble in turn affected Microsoft’s perceptions and responses. Meanwhile, with the bubble in full bloom and the trial already underway, a young man from Finland marshaled the world’s hackers into a software development bazaar, and an even younger man from Boston taught us how to share the music that we love. With that, Linux engaged Microsoft in a brewing battle over “open source” software, and Napster drew a reluctant entertainment industry into the center of an information-sector maelstrom.

These tales marked the culmination of a decades-long revolution in our computing and communications infrastructure. But while the Inter­net investment bubble and the Microsoft trial may define the current terrain of the tech sector, the Linux bazaar, the Napster song, and the responses that they engender will frame the debate about the propriety of such unfettered innovation. Though that debate has already begun to unfold, neither its underlying causes nor its relationship to the trial and the bubble has received much attention.

Think back ten years: In early 1995, computer users were split among those who favored the flexibility of Unix, those who valued the graphi­cal interface, logical layout, and tight feel of Apple’s Macintosh, and those whose preference for less expensive hardware led them to adopt Microsoft’s Windows, still a graphical interface to DOS. IBM’s imminent acquisition of Lotus would make it the world’s largest software company, capable of fielding a fully-IBM system, from the hardware, through the OS/2 operating system and an office suite built around Lotus’ popular programs. WordPerfect remained the word processor of choice. E-mail was just becoming widespread, and America Online had recently become the leading provider of network access and content to home users.

Microsoft announced that the long-awaited Windows 95 would soon provide a coherent feel that previously had been available only to Mac users. But this soon-to-be-released program omitted a convenient way to access the Internet. This omission was hardly glaring; Internet con­nectivity was rare outside the academic world. A group of students, in fact, had only recently launched Mosaic, the first user-friendly browser, and founded Netscape to commercialize it.

Laptops were almost light enough to carry comfortably, but handheld computers remained a failure despite some high-profile attempts. A few gadget freaks had CD drives built into their computers, and some of them even used their drives to play music. Cell phones were clunky, unreli­able, heavy, and mostly analog. The communications industry structure was still an artifact of the 1982 consent order breaking up Ma Bell, and questions about the property rights inherent in digital files rarely left the offices of copyright lawyers.

1995 thus began with various pieces of the revolution in place, action still needed on several key fronts, and many more audible promises than visible actions. The technologies central to the long-heralded conver­gence of computing and communications were improving; software announcements foreshadowed important innovations; and at least parts of the governing legal framework were in desperate need of an overhaul.

And then the revolution took off and the full-blown information sector emerged. By the end of 2000, Microsoft dominated personal computing with Windows and Office. Instant messaging had assumed many of the early uses of e-mail, particularly among teens and preteens. IBM’s reduced consumer focus restored Microsoft to its title of world’s largest software company. Netscape was a specter with a dwindling market share, having lost the “browser wars” to Microsoft; America Online— itself about to become AOL Time Warner¹—had acquired Netscape two years earlier. Microsoft announced the imminent release of Windows XP, Office XP, and a barrage of accompanying initiatives. Napster circulated free music software, and MP3 files were ubiquitous. Linux and Apache established a significant open-source presence in the server world popu­lated mostly by information technology (IT) professionals.

Laptops were light, easy to use, and outfitted for widely available public dataports.

In between, we lived through THE BUBBLE, that unsustainable investment frenzy built upon air and faith, rather than grounded in fun­damental analysis and due diligence. The Internet investment bubble was the central story of the information sector’s formative years. For a while, it was everywhere. And though many of us enjoyed the ride, we soon came to appreciate the wise warnings emanating from the hallowed temples of academe—warnings that we had been all too eager to ignore. Yale economist Robert Shiller’s best-selling Irrational Exuberance, for­tuitously published as the bubble approached its peak, described aspects of investor psychology that seemed to be leading to a dangerous over­valuation of the American equity markets.² His concerns transcended the inevitable losses that misguided investors would absorb when the bubble burst. He feared that the overvaluation of publicly traded companies was skewing investment decisions. It was leading the country to overinvest in selected industries while ignoring crucial infrastructure needs and other socially important goods. He perceptively saw the bubble as more than simply a phenomenon of the stock market. He recognized it as a defining social phenomenon.

Shiller aptly characterized the crowd psychology driving the bubble as a naturally occurring Ponzi scheme, a dangerous type of scam named for the 1920 efforts of noted Boston con artist Charles Ponzi. Two key ele­ments mark an “investment strategy” as a Ponzi scheme: an offer that sounds too good to be true, and a plausible explanation of its truth.

Business journalist John Cassidy accepted part of the challenge.³ He attributed the crowd psychology driving the bubble to journalism and finance—whose cognoscenti undoubtedly played a leadership role. But Cassidy’s analysis can’t answer the question because, like Shiller, he focused on crowd psychology to explain what kept the phenomenon rolling once it got started. He did not explain why the madness of the crowd began in the first place.

The answer lies in our partial absorption of the lessons of network economics. We learned the hard way that it can be dangerous to take half a lesson out of a temple and onto Wall Street. The bubble began when investors applied a fundamental misunderstanding of contempo­rary network economic theories to predict the rapid growth and domi­nance of new “pure play” companies. That misunderstanding set them on an elusive quest for “the next Microsoft,” those inevitable monopo­lists of the Internet. The deflation began when those same investors dis­covered that empirical data couldn’t sustain those theories as applied; they had omitted the critical concept of “lock in.”

Along the way, we adopted and discarded an entire theory of Internet economics: the “New World” view.⁴ According to New World thinkers, the economic laws that govern the physical world do not apply to the Internet. Instead, new economic laws emerge from three key beliefs: One, network industries, though relatively rare occurrences in the physical world, will be rampant on the Internet. Two, virtually all commerce will eventually gravitate to the Internet. Three, legacy systems will weigh down conventional brick-and-mortar companies and make it impossible for them to compete with new, nimble, Internet-savvy pure plays.

These beliefs combine to form a simple rule for New World investing. Successful first movers in an Internet space will inevitably monopolize that space. Because monopolists earn greater profits than do firms operating in a competitive environment (i.e., the monopoly rents), they’re very solid investments—particularly if you can buy their shares before anyone else notices that they’re poised to become monopolists. Equity markets value stocks based on their projected profits. If the market values a company assuming that it will earn a competitive return, and instead it earns a higher monopoly return, its price will rise and early investors will profit handsomely. So, when you think you’ve spotted a competitive company poised to become an inevitable monopolist, particularly if you’ve noticed it before the crowd, buy early and don’t worry too much about your entry point.

New World investors developed this theory at a particularly oppor­tune moment. The decline in defense spending following the end of the Cold War had forced many engineers to find new professional venues and removed what had been their most reliable source of employment. This “peace dividend” talent pool was huge, and the Internet stakes were large enough to attract a substantial number of players. Overall eco­nomic conditions were ideal for growth, and government economic policies simultaneously expanded opportunities, reduced risks, and moti­vated innovation. In this environment, it almost made sense for New World investors to use Web sites as lottery tickets. Their lottery powered history’s greatest experiment in rapid private-sector infrastructure devel­opment, created a small class of new billionaires, and left many unhappy investors and creditors to grapple with worthless shares and unpaid bills.

It also left the rest of us with much to digest. We had to consider what we’d seen unfold in the economy and how it had rippled through American—and global—society. The greatest lesson of the American economy of the 1990s may be that economic growth is the best of all possible social programs. A combination of smart policies and dumb luck helped turn the United States into a richer, more tolerant, more civil society. The unrivaled growth of the 1990s meant that so much new money was floating around that people were willing to experiment and to share. But rather than mindlessly raising taxes to redistribute wealth, we invested in long-term future growth. We experimented with a number of novel social and educational programs that expanded the base from which future entrepreneurs will emerge, while at the same time retain­ing ample rewards for our current entrepreneurs.

The information sector was central to this growth. When it entered our businesses, it made us more productive. When it entered our homes, it created new opportunities for entertainment, education, community building, and home efficiency. When it entered global society, it intro­duced new opportunities for communication, collaboration, and the spread of ideas; it provided citizens of many countries with new and exciting opportunities to participate in their country’s own development, governance, and growth. Above all, though, it got us excited about the future. The information sector’s growth made us believe in a future that was fundamentally better—a future with greater opportunities, more winners, fewer losers, and better facilities to care for the few who fall to the bottom anyway. In short, the information sector’s growth caused a blossoming of hope. Granted, we might have been better off had we tem­pered that hope with a bit more reason, but even so, the hope of a better future helped us strive for things that we otherwise might never have attempted.

The story assumed a different tenor when the bubble began to col­lapse. We learned that the information sector’s products and profits wouldn’t materialize as quickly as we’d expected. That dented our hope. We learned that some of our erstwhile heroes had lied to us. That dented it further. And then we learned the most painful lesson of all—the infor­mation sector’s spread made it easier than ever for people who hate us to expose our vulnerabilities. Our dumb luck ran out. Fear replaced hope. Security replaced growth as our overriding concern. We stopped investing in our long-term societal future and shifted our dwindling savings instead into safer arenas closer to home.

Around the same time, our policies shifted to favor the safe, comfort­able planning of dominant incumbents over the exhilarating chaos of entrepreneurial start-ups. We downplayed our investments in infras­tructure and opportunity to emphasize, instead, increased incentives— though the incentive to invest in high-risk, high-payoff, long-term ventures hardly seemed to be lacking. The second stage of the informa­tion sector’s tale unfolded glumly in this policy environment. The sector wound its way through some painful years, into the early stages of a potential recovery. It emerged with New World thinking discredited and with a view of the Internet as a “New Channel” on the rise.⁵

New Channel thinking rests upon a single modest belief: The Internet makes it cheaper for buyers and sellers to communicate with each other. As a result, the Internet alters the relative cost-effectiveness of various types of transactions—a change that’s likely to play itself out in very dif­ferent ways in different industries. In other words, there are few Inter­net companies out there. In reality, there are just a bunch of companies in different industries that have noticed a new communication channel and built it into their businesses.

We stand today at the beginnings of stage three. The only way that we can return to real hope and growth in this stage of the story is to assess what worked, what didn’t, and why. We must devise policies con­sonant with those that fostered growth in the 1990s, but which also recognize our newfound sense of vulnerability and need for security. We must learn to trust again—and in particular, to trust the corporate inno­vators and entrepreneurs who make growth possible. We must make sure that short-term rewards remain significant enough to promote invest­ment. We must focus that investment on the parts of the economy most likely to promote long-term, multiplicative productivity growth. We must spread the opportunities to take advantage of that growth as widely as possible—throughout the United States and around the world. The con­tinued growth, maturation, and health of the information sector are critical to each of these tasks. At the same time, though, we must remain vigilant; the constant attempts to censor what we see, invade our privacy, damage our economy, and kill our people unfortunately also become easier as our information infrastructure improves.

These are all tough challenges, and there’s plenty of work to go around. Governments, businesses, technologists, and scholars must work together to restore our trust, rekindle our hope, keep us safe, and let us grow. If we each do our part, we all stand to win, and the Internet will make us all rich. This enrichment will come neither as abruptly nor as easily as we once wished. We will all get a little bit richer one online transaction at a time, and we’ll have to fend off those who would prevent our enrichment. But if we don’t first believe that we can return to an era of hope and growth, we never will.