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Silicon Valley and Finland 65produces innovation in the practice of business. Venture capital operates on thebasis of high expectations of return, so that the many projects that fail are morethan compensated for by those that succeed.The returns are essentially provided by the valuation in financial markets.Here lies both the strength and the weakness of the new economy model.Global, dynamic, interdependent financial markets offer a large pool of capitalthat can be channeled through venture capital firms into innovativeprojects, which, if rewarded by high market valuation, often in anticipation ofperformance, become the endless source of new funding for a high-flyingeconomy. But this strength becomes a fundamental weakness if the valuationprocess devalues the anticipated performance of the firm.How and why do financial markets reverse themselves? They are foundedon two basic premises: (a) trust from investors in the relative stability of themarket and in the reliability of the institutions overseeing the market; and (b)expectation of a return on investment. During the 1990s, there was a period ofrelative stability in the United States, in spite of financial crises in severalemerging markets, and of widespread optimism after the end of the Cold War,along with the expansion of the global economy. Expectations of returns ontechnology stocks were high, first because of reasonable assumptions aboutthe role of innovative industries in the new economy; later, because of unwarrantedexpectations fueled by futurologists and some Internet consultants. Theshift of savings to investments in stocks, and new financial instrumentsassisted by new technologies and computer models, pushed the entire stockmarket upward. In some cases, since expectations of firms’ performance weremajor sources of valuation, and then financing, some firms engaged in“creative accounting” (namely, “cooking the books”), and some accountingfirms condoned these practices. Then, expectations reversed, when it becameclear that the dot-com companies were based on a wrong business model, andthey brought down with them, in their fall, all other technology stocks, regardlessof the actual performance of each of the downgraded companies.Deflation of expectations followed an inflation of expectations.Simultaneously, geopolitical stability was shattered and the exposure ofbusiness abuses (from Enron and Arthur Andersen to ABB and BBV) underminedtrust in the institutions of the market. Investors withdrew, drying up thesources of finance for innovation. This prompted the crisis of the new economyand of the Silicon Valley model. The same virtuous circle representedgraphically in figure 2.6 became a vicious circle of business failures.However, in the midst of the downturn, innovation continued to proceedand productivity growth was sustained. This is a fundamental feature, bothpractically and analytically. Practically, while many Silicon Valley firmsclosed down or had to retrench, laying off tens of thousands of highly skilledworkers, the heart of the high-technology industry survived, and seemed to be