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 / Summer 2003 / Issue 31(originally published by Booz & Company)


Irrational Exuberance: How the Telecom Industry Went Astray

What happens when demand myths, faulty forecasts, and financing traps converge.

Illustration by Opto Design
The business media, the stock market, and weary executives have converged on a point of view about the global telecommunications industry: It has been overwhelmed by overcapacity. Just 18 years after regulators, seeking to end natural monopolies, began to open access to competition, the number of new entrants building redundant networks exceeded the optimal level of demand, first in the long-haul fiber-optic transport segment, then in the local exchange market, and, more recently, in wireless.

Although consolidation will lead the industry back to rational pricing and allow it gradually to reabsorb the overhang, the “return to normalcy” should not obscure two questions that transcend telecom and are crucial for approaching other markets facing sudden regulatory, technological, or other disruptive change:

Why did hundreds of executives in one of the world’s most important industries — critical not only for commerce and daily life, but for national security as well — become irrational investors? And what lessons might business leaders and policymakers draw from the telecommunications industry’s experience, to avoid the “irrationally exuberant” investment decisions that brought this sector to its lowest ebb ever?

Famously introduced by Federal Reserve Board Chairman Alan Greenspan in 1996 to describe New Economy market valuations, then popularized by Yale economist Robert Shiller four years later, “irrational exuberance” describes the behavior of private investors during speculative bubbles in public stock markets. Professor Shiller defined the term as “wishful thinking on the part of investors that blinds [them] to the truth of [their] situation.” In Professor Shiller’s framework, irrational investment behavior is driven by a set of external variables, which he terms precipitating events, that supersede rigorous return-on-investment analysis. In addition, the checks and balances that are supposed to guard private investment decision making from irrational behavior are overcome by what Professor Shiller calls amplifying mechanisms, which tend to reinforce wrong investment decisions.

We propose to extend this basic concept to explain the behavior of contemporary corporate investors when they considered either their first entry (startup) or diversification (in either a new geography or a new line of business) in the telecommunications industry. A review of corporate decisions made during the past several years will show that, industry expertise and project evaluation techniques notwithstanding, corporate investment decisions — presumably made by groups of executives experienced in a company, its industry, and its markets — can be just as irrational as individual investment decisions. Further, we believe it is precisely that kind of behavior that has, in part, bred the volatility that now characterizes the industry.

In attempting to describe how irrationality can overtake an entire industry, we are employing a simple two-stage methodology. First, we develop a causality framework, validated through research carried out in the fields of behavioral finance, organizational development, information economics, and political science, that helps explain telecommunications investment decisions. Second, we draw evidence about the irrationality of recent decisions from a wealth of anecdotal findings, accepting the notion advanced by the economist Charles P. Kindleberger in his classic Manias, Panics, and Crashes: A History of Financial Crises (Basic Books, 1978) that anecdotes, if systematic, can become evidence.

Business Plan Variables
Typically, a firm’s decision to enter into a new sector of an industry follows a three-step process. It starts with the development of a business plan that defines, among other items, service offerings, target markets, the technology platform, and the distribution strategy, and assesses the return on investment. Once the business plan is completed, its sponsors search for external sources of financing to develop and launch the enterprise. The last step focuses on the search for additional funding, usually through the offer of a portion of the firm’s ownership in the public equity markets.

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