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Dot-Com Crisis

Posted by Harish at Sunday, May 10, 2009

Hi everone! I posting after a very long time. Sorry about that. Anyway recently I have been following the Global Economic Crisis. I asked many people what is the reason for it. Most of them say its because of "fast bucks". So from where did this fast bucks come from and I got the answer "Dot Com Crisis". Again I started looking for more information on Dot Com Crisis. Unfortunately there was no single page which explained about the crisis. So I am posting it here from my findings. I have removed all the figures from this. Read it if you want the information and how it happened and not the figures.

Dot–com Crisis
1. Introduction
            The dot-com crisis, also known as dot-com bubble refers to a four year period (1997-2001) during which the stock prices soared high in the Internet and technology sectors of the Western nations. The companies followed a business model called “Network effect” by which the companies gained more market share but without actually making any profit or revenue at all. Because of the large market share of the companies, the stake holders were given a false image that the companies were making huge profits. The rating agencies also gave false speculations on the individual stocks. So the were highly overvalued creating the bubble. The dot-com crisis had an effect not only on the economy of USA but also the rest of the world. This report aims to analyse the causes and effects of this economic crisis.
2. Causes of the Dot-Com Crisis
            The main reasons for the dot-com bubble are as follows
  1. The Network Effect
  2. Investment Banks
  3. Y2K Problem
  4. Microsoft Case
  5. Free Trade and Globalization
2.1. The Network Effect
            The motto of the dot-com companies was “get big fast”. Every company wanted to monopolize the market. To achieve this they used the business model name “Network effect” at the expense of the net income. A network effect is the effect one customer or user of a particular good or service has on the other users of the same or related good or service. For example, if more people purchase a telephone, it becomes valuble to the owner and inturn influences other people to also buy the telephone creating a positive loop. Some applications of the network effects model are as follows
2.1.1. Stock Exchanges
            In stock exchanges there is a difference between the price at which a stock or a security can be sold and the price at which it is sold. This is by the liquidity, that is the convertability of an asset and the transaction costs. As more number of buyers and sellers enter the market, the transaction costs decrease, the liquidity increases and the difference gets reduced resulting in better trading  prices.
2.1.2. Software Industry
            The IT industry operates very strongly on network effects. For example, during the time of the bubble growth, hardware compatability was a serious issue. Microsoft Windows was marketed as being the operating system which supports the widest range of hardware. So many customers bought Windows for its compatability. This increased the market share of Windows significantly. To capitalise on this huge market share of Windows, many hardware manufacturers made their hardware compatible to Windows which again added to the circle creating a positive loop for Windows resulting in Microsoft monopolizing the operating systems segment with Windows. Similar is the case of Microsoft Office Suite.
2.1.3. Websites
            Consider the example of eBay. The auctions in the site wouldn' t have been competitive if the number of users was less. Since the number of buyers and sellers was increasing the price of the auctions became very competitive. Similar is the case of Amazon and GOOGLE.
2.1.4. Open and Closed Standards
            In the Information Technology industry, open or common standards and interfaces were often developed by a group of companies for the mutual benefit of these companies by network effects. However, if a company maintains closed standards, positive network effects can make the company which maintains the standard a monopoly. Eg. Microsoft.
2.1.5. Mergers and Acqusitions Based on Network Effects
            Many small companies which were monopolizing a segment of the market were acquired by bigger companies with the aim of acquiring more share of the market. For example, Hotmail was bought by Microsoft, Mirabilis, a company which was monopolizing Instant Messaging (IM) was bought by America Online, Youtube and Blogger were bought by GOOGLE etc. Some of these boosted the company's market share while others were a loss to the purchasing company.
2.1.6. Positive Effects of Network Effects
            The positive effect of network effects is pretty obvious, the value which a user gets from a product is greater than or equal to the value of the product.
2.1.7. Negative Effects of Network Effects
            Suppose there are two companies and one is monopolizing the market. Now if suddenly the second company introduces a better product than the first company then if the transition cost is also less or none which is true in the case of dot-com companies, then the customers from the first company shift to the second resulting in an accelerated decrease in the market share of the first company. This is how GOOGLE won market share over Yahoo as a search engine. Yahoo's share price came all the way down from $138 to $4 in a very short time. There is one more case in which there are less or no competition to a company monopolizing the market. In such cases, the company can restrict the resources available for its users or increase the price etc. This is what Microsoft did in the operating systems segment. 
2.1.8. Usage of Network Effects by the Dot-Com Companies
            An Internet company or a dot-com company's survival is based mainly on its customer base. So the companies used network effects to gain market share even if they produced huge annual losses. For example Amazon was expanding its customer base and was spending more on pulicity and marketing while GOOGLE was spending more on creating powerful servers for its search engine. Both of these companies were not making profits during their initial years. Since Internet based business was the booming sector many companies were investing more on buying high-speed internet like broadband. This benefitted companies which provided high-speen internet service and infrastructure such as Cisco and raised their market share. Many companies even went into high debts in the process of buying this infrastructure.
2.2. Investment Banks
The investment banks in Wall Street made approximately 500 companies public during the end of 1999 and the beginning of 2000 and raised a capital of $77 billion through IPOs. For each company they charged a fee of 6 percent for making them public. This was a sort of brokerage charge. They made millions of money this way. The investment banks then demanded to invest in the companies before the IPO when the shares value was just a fraction of what it would be after the IPO. The investment banks then charged a multimillion fee for the public offering and also made more money as their investment multiplied within months. This greed of the Investment banks was one of the most crucial reasons for the dot-com crisis. Since a large amount of revenue was generated, the Wall Street and Investors failed to see the fact that these Investment banks had failed to follow the guidelines which were to be followed for making a company public. These guidelines were in place after the Great Depression. According the the guidelines, a company should be in business for a minimum of five years and should generate profit three consecutive years and should have a certain level of revenue and profitability. Since this was not followed, many companies which lacked a viable business model were made public mostly for the profit of the Investment banks and also because of the philosophy “get big fast”. After the bubble burst, these companies companies were decalared bankrupt and the investors suffered a loss of over $1 trillion.
2.3. The Y2K Problem
            By the end of 1999, the famous Y2K problem was created according to which a major computer shutdown was expected during the starting of 2000. So the Federal Reserve started to pump more money in the capital market by selling repos to deal with any financial problems that may occur due to the Y2K crisis. The companies also spent a lot of money on tackling this problem. But the Y2K crisis never happened. The business spending declined rapidly. Many companies spent their way to bankrupcy trying to fix their Y2K problem. 
2.4. Microsoft Case
            Although Microsoft was declared a monopoly by the fedral court on April 3, the result was widely expected weeks before. So the major high tech technology sector companies such as Cisco, IBM, Dell etc foresaw this and made a multi-billion dollar sell order on the March 10 weekend. The stock exchange opened on Monday, March 13 with a four percent low. This was the greatest premarket sell-off of the entire year. This major sell-off  by the major high tech companies caused a ripple effect as the investors, funds and investors began liquidating their positions by selling off their shares. In just six days from March 10 to March 15, the NASDAQ (National Association of Securities Dealers Automated Quotations – the American stock exchange) had lost nearly nine percent from 5050 points to 4580 points. This later led to the stock market crashing down which is famously termed as the dot-com crisis.
2.5. Free Trade and Globalization
            By Free Trade and Globalization the companies were allowed to act according to their wish without the intereference of the government on a global scale. So the workers in USA were put on a global level competition against one another for the lowest wages. This resulted in the factories becoming portable and were shifted towards places with cheap labour like India. This resulted in a massive hidden deflation of the value of labour. Since a large amount of money was pumped in by the Federal Reserve, the companies' stock prices were soaring while the workers were getting fired creating a bubble. The companies also failed to call it deflation. They chose to call it increase in productivity. The value of workers and labour was a real tangible asset while the bubble was just paper money which was intangible. This bubble ignored the labour value as the stock prices were soaring.
3. Aftermath of the Dot-Com Bubble
3.1. Impact on US Economy
            Several companies were faced with large debts from which they could never recover had to file bankruptcy. Some of the largest companies like WorldCom was found to use illegal accounting practices to overstate the profits by billions of dollars. Many other telecommunication companies also filed bankruptcy. The demand for high-speed broadband infrastructure was never used  resulting in the optic fibers bought being wasted without usage. This resulted in a huge loss for companies which provide internet such as Cisco and their stock prices also fell dramatically. Many of the companies ran out of capital. They were acquired by some other company or got liquidated. The top investment firms such as Citicorp, Merrill Lynch etc. were fined or accussed as fraud for misleading the investors. Thousands of employees were layed off in the name of cost cutting and business restructuring. As much as $5 trillion was wiped out of the value of the technology companies in just 18 months. All these happened to companies which did not have a viable business model. But the companies which had a successful business model like GOOGLE, Amazon, eBay, Microsoft etc emerged successful from the crisis and proved that they are fit for the long-run. Campaigns like “Buy only American products” were started to promote the internal economy of the country against globalization.
3.2. Impact on Asian Economy
            Most of the Asian countries especially those on the Asia-Pacific region were highly dependent on the dot-com companies of US. They were engaged in subordinate activities such as producing hardware, providing cheap labour etc. Because of the dot-com meltdown, the economy of these countries also crashed. Some of these countries like Thailand and Malaysia nearly faced bankruptcy.  Thousands of workers became unemployed suddenly. They had to find alternate ways to build their business on after the crisis. The ASEAN countries meeting was held and new strategies for recovery and development with new deadlines were created and the countries recovered from the crash.
3.3. Impact on Indian Economy
            India also experinced an impact of the dot-com bubble as majority of its technology and internet sector companies' stock prices fell. However the Indian IT companies were not wholly based on the US market and also these companies had sound business principles and a viable business model. So the Indian economy faced little trouble from the dot-com bubble comparitively and was able to recover easily.
3.4. Impact on European Economy
            Since the Internet sector was booming, many European countries such as Spain, Italy, England etc invested heavily on creating the high-speed internet infrastructure. They even invested heavily on internet technologies such as 3G. During this process these countires went into huge debts. Due to the meltdown, the economy of these countries was shattered. They had to find ways to repay the debts and recover from the crisis. Among the European countries Spain was the worst affected and it is still struggling to recover. 
3.5. Overall 
            After this people started to like the idea of pouring more money in a sector, giving false speculations, creating a bubble and when the stock prices rise high like anything they would pull out money. This was termed as "fast bucks". After the technology sector people started investing in the real estate sector with this newly found selfish method of earning money - "fast bucks" which lead to the present global economic meltdown.
4. Conclusion
            As a result of the dot-com crisis many companies and aspiring entreprenuers got a more realistic picture of what it takes to run a successful business. There are a few things which we can learn from the dot-com crisis. They are as follows
  1. Any business that loses money over time destroys value and does not create it.
  2. A successful business and a huge haul of wealth cannot be created in a short time. It requires hardwork, honesty and planning.
  3. Every business should thrive on its own and not based on some other business or economy which may or may not be viable.
  4. Any business should be fueled by sound business principles such as planning, management, financial control etc and not by greed.
“A greedy man is always poor.”
Comments and suggestions are always welcome