(Too Much) Free Money

I found this article on YC News today that claims that the recurring boom and bust of the Valley is somehow the Federal Reserve's fault. His only backup for this claim is a link to this article about the dangers of inflation, and the Wikipedia entry on the Fed itself. If you read the inflation article, you'll note it is from during World War II. While it rightly claims that inflation itself can be bad, the purpose is to support higher taxation and government borrowing during the second world war, not to talk about Fed policy in relation to economic bubbles. I'm not defending the Fed as perfect, the Wiki article has a whole list of criticisms, but I would ask what the better alternative would be... both to the Fed itself and (mild) inflation. The Gold Standard has been tried and found wanting, for numerous reasons. (The first link by a conservative writer, the second, by a liberal one, in case you think I am politically biased.)

Anyway, the point is that I'm confused at how the bubbles in the Valley (plural because maybe one is happening now, maybe not, time will tell) are the Fed's fault. There have been economic bubbles throughout history (South Sea Bubble, etc.). They always happen when what is normally a process played out by a small percentage of the economy (starting and funding businesses) gets popular and the rest of the economy tries to participate. Suddenly you have way more money (everyone is trying to fund small businesses and get rich) than you have startups (why come up with an idea and start your own company when you can just throw your money at someone else's Sure Thing™?).

After the bubble burst in 2000, the rich people that fund the VC firms and bought ridiculous IPO shares pulled back. They didn't pull back because it made economic sense, they did it because all the other rich people were pulling back. Markets are fickle and, much like high schoolers, move as a herd. It took a couple fantastic successes to get everyone on the bandwagon, and a couple fantastic failures to scare everyone back off it.

Here is my alternative explanation for why bubbles occur. No offense to the author of the other post, but I don't think it's due to inflation at all.

When dot coms (or Web 2.0) get popular, money comes flooding in to fund them, in the hopes of hitting the next Microsoft or Google. The thing that creates the bubble is that the number of startups doesn't increase proportionally to the money supply. There is a lag. In order to put all this money to use, everything under the sun gets funded. This is why people get money for doing nothing, as the post author claims. It's not because the Fed maintains a policy of low inflation. It's because you have too many dollars (that were probably up until recently chasing opportunities in the housing market) flooding into too few businesses.

In this case, supply creates demand. Funding becomes easy, even if you are creating no value for anyone. So, anybody with dollar signs in their eyes and a copycat idea gets funded (think Pets.com here). Of course, eventually one of these companies that is funded by easy money but has no profit potential fails as it should, and people start examining their own holdings. Maybe a couple more go down in flames, and suddenly startups look risky. Now our famously fickle investors want their money back before the next failure happens to be one they invested in. They try to dump their startups to acquirers or the IPO market. Above all, they tell themselves they will never get suckered in by dot coms and investing fads again. (Of course, two years later they create the housing boom by speculating in residential real estate.) In the sudden money vacuum, good startups get hurt because they can't find funding. The situation has reversed and now there are too many startups chasing not enough money.

My point is, the Fed has the power, and sometimes (as in the case of the housing boom/bust) the dubious honor of helping or exacerbating the boom/bust cycle. They can try to deflate bubbles by tightening up money, sucking away some of that extra funding. They can try to prop up markets by flooding the market with liquidity and cheap rates to keep people/companies spending. The thing they don't do is create the bubble to begin with, nor create the bust that invariably follows. The blame for that rests squarely on the herd mentality investors have, and the willingness of Pets.com and the like to take advantage of it.