Why America's giant tech bubble is no cause for panic

Okay folks, let's go bubble hunting. Our target for today is the famed tech bubble.

There are two big questions: One, are we in a tech bubble? And two, if we are, and it pops, how bad will it be? Let's tackle them in order.

To begin with, a bubble in the stock market basically boils down to a bunch of bets on how companies will perform — bets that then turn out to be badly off, and go bust. To a certain extent, this is always happening in the stock market. A bubble is simply when, because of some underlying structural force or trend, a lot of these bets cluster and then fall apart all at once.

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This introduces a certain inescapable existential quandary: Bets are all about risks and unknowns. Ultimately, the only way to know for sure a bet is bad is when it actually goes belly-up. But as the economist Dean Baker of the Center for Economic and Policy Research pointed out in an interview with The Week, there are at least some fundamentals you can look at, which hold true across all companies and sectors, to tell if some instance of risk-taking seems reasonable.

Let's use Uber as the obvious example. "I'm really hard-pressed to think anyone could sit down with a straight face and come up with a $50 billion valuation for Uber," Baker said. Earlier this summer, Uber raised about $1 billion from venture capital, and in exchange gave those investors a 2 percent share in the company. That implies a total value of $50 billion.

"Even the people who invested in Uber at a $50 billion valuation probably don't think Uber is worth $50 billion right now," wrote Vox's Tim Lee. "They do believe that if all goes well, Uber could be worth more than $50 billion in a few years."

Should they? That $50 billion is several times the size of the entire taxi cab industry in the U.S., and the company is very far from being able to dominate even that market. To be frank, its business model is largely based around gaming local regulations by playing with who is or isn't categorized as an employee. Legal challenges are already mounting, and if they stick, Uber's prospects could go south real quick. It's facing similar hurdles in other countries.

Even without those problems, you're assuming Uber could conquer something like half the global taxi cab market. Or at least take over the U.S. market, and then expand it multiple times over by getting into things like self-driving cars and food delivery. And it will be competing with other tech companies like Google and Lyft in this space, as well as more traditional companies. "You have to believe a lot of stuff to think Uber's going to move into this totally new market for them, and then suddenly totally dominate it," Baker said. "That's really kind of a crazy story."

As for public tech companies, Lee cited data from Andreessen Horowitz, a venture capital firm, to argue we don't face a bubble like we did in 2001. The case relies on comparing their stock prices to the projected future earnings, and that ratio hasn't gone off the charts the way it did in 2001. But, well, it's still projected earnings.

"This includes a lot of wishful thinking," Baker said. "It can prove right, but the point is usually people assume next year's earnings will look like this year's earnings, plus 20 percent, 30 percent, 40 percent." Especially in relatively new markets, which is what the tech unicorns are breaking into, get out past a few years and projected earnings amount to throwing darts at a board. Baker also noted that Apple is a huge portion of the public tech stock market, and it has an unusually low ratio "because people are betting its profits can't keep going up because they're already so huge." Pull Apple out and the ratio of stock to projected earnings in the public tech sector will probably look noticeably less reasonable.

Most of the other "unicorns" in the tech sector — companies with an implied value of over $1 billion, of which there are over 100 — face some mix of these same problems, be they shaky legal foundations, intense competition from other start-ups and established firms, or just plain weird business models.

Surely a few of them will hit it big, but that too is part and parcel of the problem. The current investments amount to a bet they'll all hit it big. But while markets aren't fixed things, they aren't infinitely elastic either, and many of these start-ups will be fighting over the same pies, be it markets in car rides, services, or eyeballs on advertisements.

The good news is that it seems really unlikely that the tech bubble, when it pops, will harm the broader economy. "Bubbles generally don't really matter," Baker said. "They matter to the people who are directly involved," i.e. the investors. But if some rich guys lose a bunch of money, there's no intrinsic reason that should worry the rest of us, outside of the workers depending on the tech sector specifically for employment.

According to Baker, there are two signs a stock bubble's effects could worm their way into the real economy: If the bubble drives up investment in the economy as a whole, and if the bubble is propping up a significant share of consumption in the economy as a whole. In those cases, a popping bubble will suck a fair chunk of demand out of the economy, and those signs were clearly apparent in 2001 and 2008.

In the late 1990s, "there was a big uptick in investment, and it was driven by the tech sector," Baker continued. "We had the highest investment share of GDP in those years since the late 1970s." But today, investment share remains much lower. The effect of more wealth in people's portfolios also encouraged them to consume more. In 2008, "the housing wealth effect was leading to huge amounts of consumption. We had savings rates hitting a new record low. All of this was easy to see." Today, the savings rate isn't stellar, but it's higher than where we were in 2001 and 2008.

"It's best you not have big bubbles," Baker concluded. "But these aren't moving the economy."