Paul McCulley Identifies The Key Difference Between Biotech Bubbles And Bubbles That Actually Matter

It's easy to look at charts like the one to the right and conclude that the dotcom bubble of the late 1990s was a lot like the credit bubble a decade later.

Sure, the stock market made similar moves.

But, no two bubbles are alike. And the last two bubbles were very different.

Time.com's Pat Regnier recently interviewed PIMCO Chief Economist Paul McCulley.

Regnier asked if we should be worried about bubbles in the stock market like the one we may be witnessing in biotech stocks right now. Here's the exchange (emphasis added):

Q: You argued the 2008 crisis was the result of good times making investors complacent. With Fed chair Janet Yellen talking about high prices for things like biotech stocks, is complacency a danger again?

A: I don't worry too much about irrational exuberance in things like biotech. It doesn't involve the irrational creation of credit, as the property bubble did. Think of the Internet and tech bubble back in 1999. It created a nasty spell, but it didn't lead to five years in purgatory for the economy either.

That distinction between a credit (bond market) bubble and an equity (stock market) bubble is an important one.

Small startups like Internet and biotech companies tend to be unusually speculative because at the start, they have no revenue. Most of the time, all of their costs lead to losses. As such, banks don't want to lend, and these companies don't want to borrow for fear of going bankrupt before they even had a shot. As a result, there isn't much credit creation going on here.

These companies, which have little or no debt on their balance sheets, are financed by investors who commit tons of equity capital with the expectations that they'll own a slice of what could one day become an extremely profitable company. That equity has the potential to swing wildly.

An extreme example of occurred during the dotcom bubble, where companies with no earnings exploded in value and then saw that value fall to zero. People went went broke as fast as they got rich during dotcom bubble.

While the dotcom bubble did cause some serious economic damage, it was relatively contained and it was nothing compared to the credit bubble that came later.

The credit bubble was marked by the U.S. housing bubble. People were buying homes, and then buying more homes, and then borrowing against those homes to buy other stuff. With home prices only going up, everyone from banks to pension funds to mom-and-pop happily financed this behavior by buying up bonds.

All of that borrowing and lending created inflated demand for goods and jobs.

But when that bubble burst, the contraction was for more devastating. Just take a look at what's known as "The Scariest Jobs Chart Ever." It illustrates how long it took for the U.S. to recover all of the jobs it lost during the last recession (red line), or the Great Recession. Compare that to the recession that followed the dotcom bubble (brown line).

The stock market may get a lot more attention on the news. However, the bond markets are much bigger (see below). And when the bond markets bust, then we've got some serious problems.