TCS Daily

Will Dot-com Failures Lead Us to Recession?

By Kevin Hassett - January 8, 2001 12:00 AM

The carnage along the dot-com landscape is stunning. Back in May 1999, a share of eToys sold for $83.56. At that price the online retailer had a stunning market capitalization of about $11 billion. Last Friday, eToys closed at a paltry 18 cents per share. Plunk down $29 million and you can buy the whole company. And eToys is hardly alone. From to, once high flyers have come to earth -- and often with a bang.

In the past, sharp declines in asset values have shown themselves capable of doing significant damage to the economy as a whole. A crash in real estate values in the late 1980's undoubtedly helped cause the recession that drove George Bush from office. And Japan is still trying to recover from an even sharper real estate collapse. Will the dot-com crash have a similar effect?

From where we sit today, the most likely path to recession starts with a credit crunch. How does that work? U.S. firms often run their businesses with a credit cycle similar to that of the midwest family farmer. During planting season, money is borrowed to buy seed. After the harvest, the loan is paid off and any remaining profits are kept. Take away the up-front credit, and the whole process can grind to a halt.

A smart lender charges risky clients higher interest rates. The hope is that the money taken in from firms that do not go bankrupt will be enough to offset any losses made from firms that do. Credit crunches happen when lenders have made so many bad loans that they simply can't find the cash (or the stomach) to lend to otherwise worthy clients. Dry up credit, and a wave of bankruptcies and layoffs starts a sharp downward economic spiral.

It is easy to see how a real estate crash can lead to a recession. Most real estate transactions are very heavily leveraged. When prices drop sharply, banks and other lenders are stuck with mountains of bad debt and severe liquidity problems. This is exactly what happened in the late 1980s in the United States.

Will a dot-com crash do the same thing? Probably not. To see why, consider the difference between the following two examples.

In scenario 1, you borrow $2 million from a bank to start a restaurant and quickly go bankrupt ---your chef stinks and the property turns out to be a hazardous waste dump. The bank that was unlucky enough to lend to you eats the loan.

In scenario 2, you start a hot dog stand in the park, paying $10,000 for the cart out of your own pocket. Fulfilling a lifelong desire to own a firm that is publicly traded, you issue 10,000 shares in your company and keep all but one share for yourself. On the first day you sell one hotdog, then two the second. The stock market becomes euphoric over your astonishing sales growth. With sales doubling every day, you will sell a billion hotdogs in less than a month!

Because of the temporary euphoria, the price of the one share in private hands soars to $200, 200 times what you expected, and the "market value" of your business skyrockets to $2 million. But the bubble doesn't last long. After a while, it becomes apparent to investors that the cart is not worth $2 million. It is only worth $10,000. Your share price plummets to $1 per share.

Who lost the money? After the crash, the poor euphoric fellow who paid $200 for your share lost $199. That's it. Your market capitalization dropped by $1,990,000, but the hard money loss was only $199. No lender is losing sleep over his loan to you. Your business will even continue to operate.

While this example is an oversimplification, something like that is at work in the Internet economy. While eToys has declined in value by billions of dollars, the company only has a few hundred million dollars in liabilities. eToys also has used its cash to acquire significant tangible assets (wharehouses, offices) that can be sold to pay off bondholders in a bankruptcy.

Scan the financial markets and the stories are similar. Nowhere do you see stories of distressed lenders. Low grade corporate bonds certainly had a bad year, but default rates are about half as high as they were in the early 1990s, and no cause for alarm. Fallout from the dot-com crash will likely not ignite a credit crunch.

So what will the new year look like? As we neared the last recession a decade ago, core inflation was close to 5 percent, and the Federal Reserve was forced to ease cautiously for fear of igniting runaway inflation. High interest rates put a lid on liquidity, and bankruptcies soared to roughly double their current pace. This time around, core inflation is about 2-1/2 percent, and there is ample room for immediate loosening. If interest rate reductions start in January, they will deliver us from recession.


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