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Part I of this circular described a coalition of confidence and complacency which is united in the view that the tech wrecks of the past year, the earnings downgrades and other sombre economic signals of recent months have dented but by no means destroyed the ability of ‘New Economy’ and ‘tech’ stocks to enrich their owners. This circular sets out four premises which (in Part III) yield a conclusion which sharply contradicts this consensus. It shows that the Internet, IT and the like are not re-writing the laws of human action. Quite the contrary: they conform to laws that have been acknowledged for at least 200 (and arguably 2000) years. If this conclusion is even roughly correct, then, as discussed in Part IV, few market participants have recognised the grave risks which – even in the wakes of ‘tech wrecks’ and present signs of recession – inhere in the ownership of ‘New Economy’ securities.
Emperors, Clothes and Mirrors
Arrayed against the members of the coalition set out in Part I is a much smaller, more disparate and in many respects virtually unknown group of ‘e-sceptics.’ These sceptics fret that the prices of ‘tech’ stocks, even at post-wreck levels, remain absurdly and dangerously inflated. They note that amazingly few (in the U.S., approximately 5 in 100) techs have real earnings; that even on the techs’ own and notoriously optimistic projections, fewer than 1 in 10 will be profitable in three years’ time; and that even in True Believers’ crystal balls, at least one-half will not exist in five years.
Sceptics also observe that most ‘Old Economy’ companies in Australia, Britain, Canada and the U.S. presently trade at 15-25 times earnings; that is to say, at current rates of earnings per share an investment in one of these companies would pay for itself in 15-25 years’ time. In contrast, in 1999 companies listed on the tech-heavy Nasdaq traded at an average of 110-120 times earnings; at its peak in 2000 at more than 200 times earnings; and presently at almost 140 times earnings. True, the median multiple among the 10 biggest (by market capitalisation) tech companies, in one enthusiast’s words, “has fallen by roughly half to just over 30 times reduced earnings estimates.” And it is also true, in this same enthusiast’s words, that “the 10 largest companies represent 40% of the Nasdaq composite’s market capitalization.” But it does not follow, as this enthusiast asserted in February 2001, that it is “fairly clear that there is no meaningful valuation issue among the Nasdaq’s leadership.” Quite the contrary: if it were to regress to its mean price-earnings ratio since 1985 then the price of the average stock on the Nasdaq would plunge another 60-70% from today’s levels.
E-sceptics also fret that the benefits of the Internet, IT and other technologies, whilst real and important, have been drastically overstated. Sceptics readily acknowledge the importance and benefits of technology to consumers; from the point of view of its owners, however, sceptics hasten to add that wealth derives at least as much from the growth of capital (as opposed to credit) as it does from technology and innovation; that capital derives ultimately from savings (and not debt); and that the laws of human action, alas, are immutable. Most heretically, sceptics note that in technological terms many so-called ‘tech’ companies are unremarkable: that is to say, the brainpower and technological sophistication required to develop and commercialise B2B IT systems, for example, is not demonstrably greater – and may well be inferior – to that required to extract oil from wells 20km offshore and 2 km below the surface.
Four Building Blocks
I concur with these sceptics’ points but go much further: although there are exceptions, I question the innate ability of technology in general and the Internet and IT in particular to create real and enduring wealth for its owners (as opposed to benefits for its consumers). Indeed, the ‘New Economy’ rests not just on unstable monetary foundations (see the circulars entitled Interest Rates, Corporate Debt and the Business Cycle); its economic fundamentals are surprisingly weak (see also The Internet and Value Investing). To see this, consider four premises:
#1: Subjective Value
The value of any particular good or service does not inhere in the good itself; rather, it resides in individuals’ subjective perceptions, judgements and calculations about the good and the various ends which it might serve. These perceptions vary from one person to another; for any given person they also vary from one time to another. Hence the value of a given good is subjective: it will vary from one person to next and from one time to another.
#2: Diminishing Marginal Utility
To say that the valuation of a good is subjective is not to say that it is arbitrary. Quite the contrary: rigorous statements can be derived from first principles about the process individuals use in order to ascribe value to goods and services. Most notably, an individual’s valuation of a given amount of a particular good derives partly from his assessment of the good’s marginal utility. The value of any individual unit of a stock of identical goods in an individual’s possession, in other words, is equal to the least important (marginal) alternate use to which the individual perceives that the unit can be put. Individuals strive to place the limited resources at their disposal to the most highly-valued uses. Once these uses are met, each additional unit of a stock of identical goods will be allocated to a lesser-valued use than was previously possible; and the value attached to each additional (marginal) unit will be lower than that assigned to previously-held units.
Consider, for example, a Robinson Crusoe who successively finds one fertile field, then a second one, then a third. Each field is identical to (and hence interchangeable with) the others. The first field will be assigned to the fulfilment of the most urgent wants (such as the cultivation of foodstuffs essential to his survival). When the second field is found, it will be put to work satisfying the most urgent wants that have not yet been satisfied (such as the cultivation of crops not essential to survival but of which Crusoe is very fond). The wants which field #2 satisfies are clearly ranked lower by Crusoe than the wants that field #1 has satisfied. Similarly, field #3 might be capable of rendering the same service as the others, but it will be put to work satisfying the highest of the remaining wants satisfied by neither #1 nor #2 (e.g., the cultivation of colourful and aromatic flowers). Under these conditions the value to Crusoe of any one of his three equivalent fields is equal to his subjective assessment of the value of the least-urgent (‘marginal’) wants which they are able to serve.
As the number of units of an identical good in one’s possession decreases, on the other hand, the value to the individual of the least important (marginal) use to which this decreased available stock can still be applied will increase. If a rockslide destroys field #2, for example, then Crusoe will be able to satisfy fewer of his wants. Given his ranking of wants and the two remaining fields’ ability to satisfy them, he will therefore cease the cultivation of flowers and shift field #3 to the cultivation of crops not essential to survival but of whose taste he is very fond. Under these conditions the value to Crusoe of any one of his two remaining fields is equal to his subjective assessment of the value of the least-urgent wants which they are able to serve, i.e., non-essential foodstuffs. Crusoe has fewer fields, they can fulfil fewer of his wants and their subjective value to him has therefore increased.
#3: Exclusion of Supply
The greater the degree to which a good’s supplier (actual or potential) can in principle exclude a consumer from the good’s use and enjoyment, the more the characteristic of exclusion applies to a transaction involving that good. Given a medium of exchange, an ‘exclusive’ good changes hands voluntarily only if its supplier is willing and able to sell it to a consumer; that is to say, the consumer (buyer) agrees to conditions which are set by its supplier (seller). That these conditions may be perceived as generous or onerous by one of the parties to the transaction – i.e., that there may be buyers’ markets and sellers’ markets – is beside the point. Rather, the point is that the supplier can always, if he so chooses, exclude the consumer from the ‘exclusive’ goods in the supplier’s possession by refraining from undertaking the transaction. You might, for example, like to eat a Big Mac or board a ferry; but if you cannot pay then McDonald’s and the ferry operator can prevent you from enjoying the good and service in question.
Exclusion, then, does not inhere in a good per se; rather, it inheres in its suppliers’ perceptions about transactions involving the good. Exclusion of supply, in other words, is not a matter of objective logic but rather of the supplier’s subjective assessment of the opportunity cost of an exchange with a potential consumer. At any given point in time the feasibility of exclusion with respect to a given good will vary from one supplier to another; and over time a given supplier’s assessment of the feasibility of that good’s exclusion will vary. Exclusion is thus feasible (infeasible) to the extent that the supplier’s assessment of the cost of its enforcement is acceptably low (prohibitively high).
#4: Jointness or Rivalry of Consumption
The greater the degree to which a given individual can without any diminution of enjoyment consume a good simultaneously with others, the more the characteristic of ‘jointness’ applies to that consumer’s use of the good. Conversely, the more the consumption of a good by many users diminishes their enjoyment or assessment of its quality, the more the good’s consumption is characterised as individual or ‘rival.’ Clearly, then, as with exclusion so too with jointness: its assessment is a subjective matter. Most people would agree that only one person can consume a particular Big Mac. Only a handful can ride simultaneously in the same motor car; a limited (but probably larger) number can ride in a bus at one time or cross a bridge in an hour; and a very large number can observe a sunset. Yet in each instance the number that can do so comfortably is a subjective matter.
To say that the consumption of a good is perfectly joint is implicitly to say that the good is effortlessly and equally available to all in a state of limitless abundance. To say this, in turn, is to imply (given the law of diminishing marginal utility) that individuals will impute no subjective value to the good. To say that the consumption of a good is perfectly joint is therefore to say a great deal: it is in effect to deny that individuals have an incentive to produce, own or exchange marginal units of this good. It is also to deny that consumers have an incentive to establish and maintain property rights with respect to this good. Indeed, under these conditions we cannot talk of marginal units of a ‘good’ or of ‘property’ at all. Rather – examples include air and sunlight – we are talking about natural and pre-requisite conditions of human welfare. We should therefore harbour under no illusions about the rarity of truly non-rival consumption. As a general rule, the less (more) rival the consumption of a good, the less (more) individuals have an incentive subjectively to impute economic value to it, the less (more) the law of diminishing marginal utility applies to it – and, other things equal, the less (more) they will have an incentive to produce it and create and maintain property rights over it. The sombre implications of this statement for knowledge, information, technology – and the ‘New Economy’ and ‘tech’ stocks – are set out in Part III.
...continued in Part III
 
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