The New York TImes published a nice article today on David Kirsch and the Dot-Com Archive that he curates at the University of Maryland. The article briefly mentions a paper that David, Brent Goldfarb, and I published in the Journal of Financial Economics a few years ago. As the article mentions, our paper interprets the Dot-Com bubble as a strategy gone wrong—too many startup firms adopted "Get Big Fast" strategies (trying to emulate Yahoo!, Google, eBay, and Amazon), when they would have had better success targeting smaller niche markets.
However, the article does not mention that our paper also makes a broader contribution to the theory of investment bubbles and crashes in general—one that can help us interpret more recent events in markets like residential housing, public equities, and mortgage backed securities. The basic insight is that straightforward herding behavior among the relatively well-informed financial fund managers (like venture capitalists, hedge funds, and investment banks) can lead to a boom-bust cycle because these intermediaries are managing the funds of less informed investors (like pension funds, institutional investors, and individuals). A herd forms among the fund managers when enough of them decide that a certain kind of security or asset is a good investment that the rest find it optimal to "pile on" without investigating the fundamentals any further. Such a herd can be temporary and self-correcting, as the fund managers learn about the investment over time. However, investors on the outside, like you and me, don't know as much as the people we hired to manage our funds, and we don't fully trust them either because they're not playing with their own money. What Brent, David, and I showed in the paper is that once a bubble starts to pop, we (the investors) may find it optimal to withdraw our funds entirely, just as our fund managers have corrected their strategies to account for the collapse of the bubble.
In the current financial crisis, we can see these kinds of effects, as banks raise their interest rates and collateral requirements, investors "flee to quality" and seek refuge in treasury securities, and investment banks fail one after another. To make these ideas concrete in the context of a current crisis, we can think of AAA-rated corporate bonds (rather than equity shares in Dot-Com startups) as the overvalued security, mutual fund managers (instead of venture capitalists) as the well-informed intermediaries, and blindly trusting the bond rating agencies (rather than Get Big Fast) as the misguided strategy. According to our theory, once we see corporate bonds starting to crumble, we investors can find it optimal to withdraw from the corporate bond market in favor of Treasury bills, even though our mutual fund managers are learning to do a better job gauging the default risk of bond-issuing firms.
What does it take to get the market started again under this theory? We investors need to see some evidence that the financial intermediaries are investing wisely again. An infusion of government equity into the financial industry may help, if it gives the intermediaries a chance to demonstrate that they can be trusted once again. Otherwise we can get stuck in a bad equilibrium in which nobody invests because the intermediaries haven't demonstrated that they are trustworthy, and the intermediaries can't demonstrate that they are trustworthy because nobody is investing. So the theory suggests that the kinds of financial bailouts currently underway might actually be useful.