Investors are primarily driven by price signals.

When a certain area of business shows unusually high profits, speculators flock to that sector in an attempt to exploit the opening. As the sector becomes saturated with capital, profits erode due to competition, until further investment in the area offers paltry or non-existent yields.

I’m not the person to teach a fresh student about the entire study of Austrian economics. What I do know is that the majority of major corporations rely on economists from the Chicago and Keynsian schools for advice. Orthodox economists harbor strange beliefs about the role of money in an economy. Broadly put, they believe that money is a separate class of commodity that’s largely unaffected by the laws of supply and demand.

This is untrue.

Central banks and governments often work to encourage credit to expand in a particular sector because it meets political purposes. For example, President George W. Bush famously encouraged the expansion of home mortgages, home equity loans, and home equity lines of credit throughout the 2000s. Construction companies, home improvement services, and real estate brokers thrived – until many of those loans became non-performing, eliminating much of the profit from the sector.

Venture capitalists since the 1990s have focused on promoting businesses online.

Online businesses have a number of tax-related advantages compared to traditional ones. Hosting and domain name registration are much less expensive than renting a shop. When you sell something online, it’s usually not subject to sales tax and other state duties. You can sell obscure, niche products at greater profit online. Online advertising is inexpensive and easier to measure in terms of effectiveness than conventional ads.

The Equity Bust

It’s no secret that the future of venture-backed startups is questionable. The market for acquisitions is frankly quite confusing to me. The results of the AOL acquisition of Bebo seems to me to be more the norm than an exception. Before you blame AOL’s management for the destruction, Google failed to make Dodgeball profitable after a similar big-ticket acquisition.

These companies aren’t run by idiots. Despite founder complaints to the contrary, I doubt that the “corporate culture” was the real problem.

The issue is fundamental. These social networking and data collection services are not capital-intensive. People can and do create these services for less than $1,000. It only takes time, some programming know-how, and inexpensive methods to promote them sans advertising.

Capital is necessary to develop complex technical services, pay for servers, and to keep high-grade experts on the payroll.

Social networking and anything involved in it requires none of these things. It makes very little sense as a target for capital investment.

That’s partly why returns have been so garbage.

Facebook is, of course, the most famous example of this issue. Although they’re earning substantial revenue, the company needs to go public to repay all the shareholders adequately. It’s possible that they’ll be able to accomplish it, but lackluster market performance probably means that many of the investors will be less wealthy than they hoped.

It’s actually kind of pathetic that despite hundreds of millions of users, each user is worth a few dollars at most. In a company that raised less money and had a smaller staff, it’d be in a beautiful position. But now it’s required by shareholders to contort its business model severely in order to ensure adequate returns for investors.

Political Risk in the United States

Political risk is anathema to long-term business planning. Ordinary sorts of risk can be hedged against. But with politics, your business can take a bullet in the head without warning. The classic type of political risk is outright nationalization. But there are other kinds of risk.

For example, Senator Schumer wrote a threatening letter to Facebook about its privacy policies. The government, of course, has the power to impede Facebook’s IPO or to convene some kind of regulatory agency that can dictate how Facebook services its customers.

Internet businesses have enjoyed relative freedom from regulation. The sector came to maturity under a government with a relatively laissez-faire orientation to this new sector.

The overall philosophy of the 1990s – that evaporated after the 9/11 attacks – was to gradually dismantle the 20th century regulatory apparatus to encourage economic growth. While support for the mixed economy remained firm among the political classes, there was a general understanding that freedom from regulation would encourage economic growth in the long run.

This deregulation process ultimately failed, with explosions like Enron and even the acquisition of Broadcast.com by Yahoo scarring the public mind. The Federal government made too many promises about being capable of cracking down on state-level regulations than could be fulfilled. The multi-billion dollar giveaway to telecommunications companies intended to induce broadband internet expansion was a colossal failure. The companies either sat on the money or were stymied in their attempts to expand by the demands of municipal governments.

And in any event, the deregulation was asymetric. While internet companies like Amazon enjoyed a largely regulation-free existence, manufacturers, utilities, and others were kept frozen in the past by the regulatory regime.

In that manner, innovation was allowed in a small sector – and provided with massive tax and regulatory advantages – that allowed it to dominate in terms of growth.

Now, as the FCC and other agencies demand more regulatory authority over online business, entrepreneurs and investors are at a crossroads.

Hedging Political Risk

The dominant philosophy in tech-related business is to be numbers-driven.

This, I believe, is in part misguided and based on epistemological error. Venture capitalists and other investors are not stupid people. They’re generally among the most intelligent, best-connected, most knowledgeable, and honest people around.

The trouble is extrapolating a trend into the future based on past averages. It’s also in mistaking meaningless “metrics” for profit potential. Myspace had metrics out the wazoo. So did Geocities. Both were horrific malinvestments.

The reliance on metrics over profits to make investing decisions is fading away as more intelligent investors recognize that nothing will replace basic economics.

There are few exits these days for conventional venture-backed startups because the failure rate is too high. Unless you’re an investment bank that can borrow from the discount window, blowing hundreds of millions of dollars on a startup with questionable profit potential seems rather stupid.

It makes no sense to me as to why a company would spend $500 million or more on a startup if they could just send several employees into a corner office to develop the new technology in a skunk-works or other kind of incubator.

There are always anomolies – like Gilt Groupe and Groupon – but those are both businesses that sell real products. They’re not just nebulous web toys that have a vague promise of someday making money. They use the web to sell real products and services. They’re bread-and-butter businesses that use technology to sell stuff.

If Bebo couldn’t turn a profit after being acquired for $850 million, it’s unlikely that similar services like Ning will be capable of doing one better.

The venture-backed world is littered with the corpses of social networking sites. Because any teenager can set up a social networking website.

It’s a commodity in nearly limitless supply.

And anyway, most of what gets attention these days are retreads from the 90s.

There’s not much that differentiates Chatroulette from various webcam prostitution services that popped up during the 1990s. It even features plenty of dicks.

Technology on the web has developed relatively little. The scale has increased and aesthetic sensibilities have become more refined, but the growth in the sector has been driven primarily by getting more people on the internet rather than actual technological change.

My favorite example is the cell phone network. The United States was one of the last developed countries to get 3G connections. The populace in the US was years behind the rest of the world in mobile technology until the FCC and the state-managed telecoms finally got around to opening up the spectrum.

Another example is Twitter. Fundamentally, Twitter is little different from an instant messaging service or chat room. It’s organized in a different manner than previous direct communications technologies, and the company managed to market the service to a mainstream audience.

It’s unprofitable, and will probably only become profitable if it finds a spendthrift suitor willing to pay a price exponentially higher than its earnings.

Concerns About Fraud

Many venture capitalists are partly compensated as a percentage of assets under management. This means that their primary short-term incentive is to raise as much money as possible. Even if they endure catastrophic failures, they still collect a substantial paycheck. Of course, if they want to survive in the business for decades, they have to provide returns to their investors to build a reputation.

I strongly doubt that the majority of venture capitalists are actually out there to defraud investors. However, whenever there’s “other people’s money” involved, the true believer syndrome follows closely. People can do amazing amounts of mental gymnastics to justify fraudulent behavior.

Plenty of people that would have otherwise invested their money in conventional instruments are apparently rushing into entrepreneurial funds.

I hesitate to start moralizing about investors, because persistent low interest rates make this kind of doomed bubble inevitable.

Lest I be accused of undue projection, my very first entrepreneurial ventures were somewhat fraudulent. In High School, I would write people’s papers for them and recruit people into my ‘groups’ for a $50 fee – after which I would do all the work for them.

I’ve never plagiarized anything myself – I write original material faster than I could copy and adapt it – I did aid and abet unethical behavior as a matter of course. I continued this practice to a lesser extent in college, writing midterms and final exams at $500 a pop. I would skim the entire semester of reading in a few hours and then manufacture a paper with the proper quotes.

Those were relatively minor transgressions, but it made up a pattern of unethical behavior. I decided to make a firm break with the past when I left college, and decided to live as honestly as I possibly could.

In the long run, integrity is the only policy that works.