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Understanding Money

The Internet Bubble

In thinking about the Internet and money, it is important to remember that the Internet is not an isolated environment. When you buy and sell, you are participating in the general economy. Too many people have made the mistake of thinking that the Internet is a world unto itself and that, somehow, the regular rules of commerce do not apply.

In the late 1990s, there was a boom in Internet-related stocks, particularly in new enterprises that were set up specifically to do business on the Internet, the so-called DOT-COMS. (The name comes from the way in which Internet addresses are pronounced. For example, is pronounced "Harley-dot-com".)

Within a relatively short period of time, the price of Internet stocks increased enormously, and there seemed to be no end in sight. People would buy stock at a highly inflated price and, a short time later, be able to sell the stock to someone else at an even higher price. Many dot-com companies would issue stock for the first time and, within days, watch the price soar, even though the companies weren't making a profit. In fact, virtually all of the dot-coms were losing money.

Traditionally, the value of a stock is tied to the company's earning potential. If people feel that a company's profits are going to go up, they will bid up the price of the stock. Conversely, if people feel that a company's profits are going to go down, they will sell their shares and the stock price will fall. In the late 1990s, Internet stocks were different. In spite of the fact that very few dot-coms were profitable, their stocks kept going up and up with no end in sight.

This phenomenon is not new, especially to veteran watchers of the stock market. From time to time, a particular type of stock becomes fashionable and prices rise unrealistically as investors follow the trend and jump in blindly in search of easy money. When this happens, the herd mentality creates a bubble. However, the bubble is based solely on speculation and, eventually, it bursts.

It happened in the late 1960s, when the so-called Conglomerates were, for a time, the darlings of Wall Street. A few years later, in the early 1970s, another bubble formed and burst, based on a group of well-known stocks called the Nifty Fifty. And now, in the late 1990s, it was happening again with Internet stocks.

The Internet bubble grew for several reasons. First, there was greed, always an important factor in the stock market. Second, there was a fundamental misunderstanding of Internet technology and how it affects business. Finally, there was the widely accepted belief that the Internet had changed the rules of the game. People talked about the "New Economy", one in which the dot-coms would be able to create massive amounts of wealth in ways that traditional companies could not. This idea, of course, was wrong. Any company, even a dot-com, must show a profit to be considered valuable, and, in the long run, the price of a company's stock will come to reflect the company's profitability: no exceptions.

Eventually, of course, the party was over. At the beginning of 2001, the once high-flying Internet stocks began to plunge sharply and, within a few months the bubble burst, resulting in billions of dollars of losses.

Interesting enough, the Internet does have a profound effect on the economy. However, it is not the magic force that would create a New Economy, the one the speculators loved to fantasize about. Rather, the Internet affects the economy in a way that is more subtle but much more enduring.

In order to explain what I mean, I need to digress for a moment to talk about a strange sounding idea, the "velocity" of money.

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